Fair Credit Markets: Using Household Balance Sheets to Promote Consumer Welfare

Access to credit can provide a path out of poverty. Improvidently granted, however, credit also can lead to financial ruin for the borrower. Strangely, the various regulatory approaches to consumer lending do not effectively distinguish between these two effects of the lending process. This Article develops a framework, based on the household balance sheet, that distinguishes between lending that is welfare enhancing for the borrower and lending that is potentially (indeed likely) ruinous, and argues that the two types of lending should be regulated in vastly different ways. From a balance sheet perspective, various kinds of personal loans impact borrowers in vastly different ways. Specifically, there is a difference among loans based on whether the loan proceeds are being used: (a) to make an investment (where the borrower hopes to earn a spread between the cost of the borrowing and the returns on the investment); (b) to fund capital expenditures (homes, cars, etc.); or (c) to fund current consumption (medical care, food, etc.). From a balance sheet perspective, this third type of lending is distinct. Such loans reduce wealth and are correlated with significant physical and mental health problems. In contrast, loans used to acquire capital assets (i.e. houses) are positively correlated with such socioeconomic indicators. Payday loans are the paradigmatic example of the use of credit to fund current consumption. Loans to fund current consumption reduce the wealth of the borrower because they create a liability on the “personal balance sheet” of the borrower, without creating any corresponding asset. The general category of loans to fund current consumption includes both loans used to fund unforeseen contingencies like emergency medical care or emergency car repairs, and those used to make routine purchases. Consistent with the stated justification for creating these lending facilities, which is to serve households and communities, the emergency lending facilities of the U.S. Federal Reserve should be made accessible to individuals facing emergency liquidity needs. Loans that are taken out for current consumption but are not used for emergencies also should be afforded special regulatory treatment. Lenders who make non-emergency loans for current consumption should owe fiduciary duties to their borrowers. Compliance with such duties would require not only much greater disclosure than is currently required. It also would impose a duty of suitability on lenders, which would require lenders to provide borrowers with the loan most appropriate for their needs, among other protections discussed here. These heightened duties also should be extended to borrowers when they take out a loan that increases the debt on a borrower’s balance sheet by more than 25 percent.