When people take out loans they typically do so to spend and with the UK economy in its current state, many would argue that this is a good thing. The ‘payday loan’ industry took advantage of the weak economy and the squeezed households in the UK and for the past few years, we have seen constant adverts that will appeal to many households. But, is the industry as competitive as the adverts would have us believe?
An inquiry into this industry has been on-going for some time, and it has now been referred to the Competition Commission, due to ‘deep-rooted problems with the way competition works’. For some, a payday loan is a short term form of finance, but for others it has become a way of living that has led to a debt spiral. Frank McKillop, policy manager at Abcul said:
There is a clear demand for instant credit and across the country we are increasingly seeing members who have debts with multiple payday lenders and a record of rolling over debts, or going to one payday lender to clear the debt to another.
One problem identified by the OFT is that customers have found it difficult to compare costs and this has led, in some cases, to customers paying back significantly more than they originally thought. Customers being unable to repay loans will ring warning bells for many people, with no-one wanting a return to the height of the credit crunch.
The OFT has criticized payday loan companies for competing not on costs, but on the speed of approval and using certain unapproved tactics as part of their advertising. The selling point of such companies is that you can have the money in a very short time period. However, the criticism is that this leads to loans being given to those who are unable to afford them. Key credit checks are not being done and with late night texts being sent to often financially vulnerable people, it is no wonder that complaints have been received. In a statement, the OFT said:
The competitive pressure to approve loans quickly may give firms an incentive to skimp on the affordability assessment which is designed to prevent irresponsible lending and protect consumers.
[the business models of companies were] predicated on making loans which are unaffordable, leading to borrowers paying far more than expected through rollovers, additional interest and other charges.
While payday loans are legal and there are many companies offering them, it is what they are competing over, which seems to be in question. The industry itself has begun to change its practices, providing more information to customers, only allowing loans to be rolled over three times and the potential to freeze repayments if the customer gets into financial difficulty. If more stringent checks are completed and hence timing does not become the only grounds for competition, then the problems above may become less significant. With the ongoing OFT inquiry into the practices of the payday loan industry and the continuing demand for such financing, it is likely that we will see much more of both the good and the bad that it has to offer. The following articles consider the investigation.
Webcasts
Balls warns against payday loans ‘blank cheque’ BBC News (27/6/13)
Payday lender investigation could be delayed by bureaucracy Telegraph, Steve Hawkes (27/6/13)
Payday lenders to face ‘tougher restrictions’ on advertising BBC News, Simon Gompertz (1/7/13)
Payday lending rates BBC News, Julio Martino and Stella Creasy (2/7/13)
Articles
Regulator to investigate payday loan industry Financial Times, Elaine Moore and Robert Cookson (27/6/13)
Q&A: Payday loans BBC News (31/5/13)
Payday loans: reining in an industry that is a law unto itself Guardian (27/6/13)
Payday loans industry to face competition inquiry BBC News (27/6/13)
Payday loans firms face competition inquiry Sky News (27/6/13)
Payday loans market faces competition inquiry Guardian, Hilary Osborne (27/6/13)
OFT refers payday loans to Competition Commission Scotsman, Jane Bradley (27/6/13)
Five reasons why we all need to worry about payday lenders Telegraph, Emma Simon (27/6/13)
OFT documents
Payday lending compliance review Office of Fair Trading (27/6/13)
Questions
- Into which market structure would you place the payday loans industry? Make sure you justify your answer.
- What is the role of the (a) the OFT and (b) the Competition Commission? Do these authorities overlap?
- What part does advertising play in this industry?
- To what extent is the payday loan industry a possible cause of another credit crunch?
- Why has the OFT referred this industry to the Competition Commission?
- To what extent are payday loans an essential part of an economy?
In the blogs The capital adequacy of UK banks and A co-operative or a plc? we focus on how British banks continue to look to repair their balance sheets. To do so, banks need to ‘re-balance’ their balance sheets. This may involve them holding more reserves and equity capital and/or a less risky and more liquid profile of assets. The objective is to make banks more resilient to shocks and less susceptible to financial distress.
This will take time and even then the behaviour of banks ought to look like quite different from that before the financial crisis. All of this means that we will need to learn to live with new banking norms which could have fundamental consequences for economic behaviour and activity.
The increasing importance of financial institutions to economic activity is known as financialisation. It is not perhaps the nicest word, but, in one way or another, we all experience it. I am writing this blog in a coffee shop in Leicester having paid for my coffee and croissant by a debit card. I take it for granted that I can use electronic money in this way. Later I am going shopping and I will perhaps use my credit card. I take this short term credit for granted too. On walking down from Leicester railway station to the coffee shop I walked past several estate agents advertising properties for sale. The potential buyers are likely to need a mortgage. In town, there are several construction sites as Leicester’s regeneration continues. These projects need financing and such projects often depend on loans secured from financial institutions.
We should not perhaps expect economic relationships to look as they did before the financial crisis. The chart shows how levels of net lending by financial institutions to households have dramatically fallen since the financial crisis. (Click here for PowerPoint of chart.)
Net lending measures the amount of lending by financial institutions after deducting repayments. These dramatically smaller flows of credit do matter for the economy and they do affect important macroeconomic relationships.
Consider the consumption function. The consumption function is a model of the determinants of consumer spending. It is conventional wisdom that if we measure the growth of consumer spending over any reasonably long period of time it will basically reflect the growth in disposable income. This is less true in the short run and this is largely because of the financial system. We use the financial system to borrow and to save. It allow us to smooth our consumption profile making spending rather less variable. We can save during periods when income growth is strong and borrow when income growth is weak or income levels are actually falling. All of this means that in the short term consumption is less sensitive to changes in disposable income that it would otherwise be.
The financial crisis means new norms for the banking system and, hence, for the economy. One manifestation of this is that credit is much harder to come by. In terms of our consumption function this might mean consumption being more sensitive to income changes that it would otherwise be. In other words, consumption is potentially more volatile as a result of the financial crisis. But, the point is more general. All spending activity, whether by households or firms, is likely to be more sensitive to economic and financial conditions than before. For example, firms’ capital spending will be more sensitive to their current financial health and crucially to their flows of profits.
We can expect particular markets and sectors to be especially affected by new financial norms. An obvious example is the housing market which is very closely tied to the mortgage market. But, any market or sector that traditionally is dependent on financial institutions for finance will be affected. This may include, for example, small and medium-sized enterprises or perhaps organsiations that invest heavily in R&D. It is my view that economists are still struggling to understand what the financial crisis means for the economy, for particular sectors of the economy and for the determination of key economic relationships, such as consumer spending and capital spending. What is for sure, is that these are incredibly exciting times to study economics and to be an economist.
Data
Statistical Interactive Database Bank of England
Articles
Cut in net lending to non-financial firms raises credit worries Herald Scotland, Mark Williamson (25/5/13)
Loans to business continue to shrink despite Funding for Lending Scheme Wales Online, Chris Kelsey (3/6/13)
Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Co-operative Bank to list on stock market in rescue deal The Guardian, Jill Treanor (17/6/13)
Troubled Co-operative Bank unveils rescue plan to plug £1.5bn hole in balance sheet Independent, Nick Goodway (17/6/13)
Co-op Bank announces plan to plug £1.5bn hole Which?(17/6/13)
The Co-operative Bank and the challenge of finding co-op capital The Guardian, Andrew Bibby (13/6/13)
Co-op Bank seeks to fill £1.5bn capital hole Sky News (17/6/13)
Central banks told to head for exit Financial Times, Claire Jones (23/6/13)
Stimulating growth threatens stability, central banks warn The Guardian (23/6/13)
BIS Press Release and Report
Making the most of borrowed time: repair and reform the only way to growth, says BIS in 83rd Annual Report BIS Press Release (23/6/13)
83rd BIS Annual Report 2012/2013 Bank for International Settlements (23/6/13)
Questions
- What is meant by equity capital?
- How can banks increase the liquidity of their assets?
- Explain how Basel III is intended to increase the financial resilence of banks.
- What do you understand by the term ‘financialisation’? Use examples to illustrate this concept.
- How might we expect the financial crisis to affect the detemination of spending by economic agents?
- Using an appropriate diagram, explain how a reduction in capital spending could affect economic activity? Would this be just a short-term effect?
- What does it mean if we describe households as consumption-smoothers? How can households smooth their spending?
The pricing model for low-cost airline seats seems simple. As the seats get booked, so the price rises. Thus the later you leave it to book, the more expensive it will be. But, in fact, it’s not as simple as this. Seat prices sometimes come down as the take-off date approaches. So what is the pricing model?
The general principle of raising prices as the plane fills up still applies. This enables the airline to discriminate between passengers. Holidaymakers and those with flexibility about when, and possibly where, to travel tend to have a relatively high price elasticity of demand. People who wish to travel at the last minute, such as businesspeople and those facing a family emergency, tend to have a much lower price elasticity of demand and would be prepared to pay a higher, possibly much higher, price.
With relatively high fixed costs for each flight, low-cost airlines need to fill, or virtually fill, their planes if they are to make a profit. And it’s not just about the direct revenue from ticket sales. Low-cost carriers also rely on the revenue from selling extras, such as on-board refreshments, hold luggage, hotels, car hire and travel insurance. With variable costs being tiny, the pricing model is about maximising revenue for each flight. So the fuller the plane, the better it is for the airline.
The airlines are very experienced in estimating demand over the period from a flight coming on sale and the departure date. If they get it right, then prices will indeed rise as take-off approaches. But sometimes they get it wrong. If, as time passes, a given flight is filling up too slowly, then it makes sense to be more flexible on prices, cutting them if necessary. Pricing may be easy in principle; but not always easy in practice!
Article
Low-cost air fares: How ticket prices fall and rise BBC News, Erica Gornall (21/6/13)
Papers
Pricing strategies of low cost airlines Air Transport Group, Cranfield University, Keith J Mason (2002)
Pricing strategies of low-cost airlines: The Ryanair case study Journal of Air Transport Management, 15, Paolo Malighetti, Stefano Paleari and Renato Redondi (2009)
Questions
- Does a low-cost airline always charge lower prices than a traditional scheduled airline? If not, why not?
- Identify the various reasons why holidaymakers may have a relatively elastic demand for a particular flight?
- Explain the system of ‘buckets’ of seats?
- Are low-cost airlines engaging in price discrimination and, if so, which type?
- Are there any variable costs of operating a particular flight (assuming that the flight does actually take place)?
- If demand for a flight becomes less elastic as the date of departure gets nearer, why might a budget airline choose to lower the price, at least for a few days?
- Why can Ryanair operate with lower costs than easyJet?
- Would it be in low-cost airlines’ interests to charge more (a) to overweight people; (b) for using the toilet?
Over the past few years, the term ‘bail-out’ has been a common phrase. But, what about the term ‘bail-in’? The latest bank to face financial ruin is the Co-operative Bank, but instead of turning to the tax-payer for a rescue, £1.5 billion will come from bond holders being offered shares in the bank. This will mean that the bank will become listed on the stock market.
Back in 2009, the Co-operative Bank bought Britannia Building Society and it seems that this was the start of its downfall. It took over many bad mortgage loans and loans to companies, and these played a large part in its current financial difficulties.
In order to rescue the bank and raise the capital needed to absorb current and future losses, without turning to the tax-payer, bond-holders of £1.3 billion of loans to the bank will be asked to swap them for shares and bonds, thus leading to significant losses for them. These bond-holders include 7000 private investors.
Since the financial crisis five years ago, the conventional banking model has seen much criticism and many suggested that the mutual structure of the Co-operative provided a better model, creating trust, due to its many stakeholders, who are not as focused on profitability and returns as those shareholders of a listed bank. However, the problems of the Co-operative seem to have put paid to that idea. The bail-in will mean that the bank is now listed on the stock market and thus will have shareholders expecting returns and profitability. This will undoubtedly change the focus of the bank. Euan Sutherland, the new Chief Executive said:
We are very clear that the bank will remain true to responsible and community-based banking and retain its ethical investment stance … Clearly there are lessons to learn and clearly there will be a time to look back and do that but, to be honest, in the last six weeks, where I have been involved with the Co-operative group, we have focused on driving a very solid future for this bank.
The good news is that the savings of those in the Co-operative are safe and taxpayers will not have to fork out any more money.
Yet, the co-operative structure of the bank has long been praised by customers and government alike. But is it perhaps this structure, which has led to its collapse? Furthermore, will the change in structure that will see it listed on the stock market, lead to a change in its approach to banking? The following articles consider the latest bank to run into difficulties.
Webcast
Co-op Bank unveils rescue plan to tackle the £1.5bn hole BBC News (17/6/13)
Articles
Co-op Bank travails show weakness of mutual model Financial Times, Sarah Gordon (21/6/13)
Co-operative Bank to list on stock market in rescue deal The Guardian, Jill Treanor (17/6/13)
Troubled Co-operative Bank unveils rescue plan to plug £1.5bn hole in balance sheet Independent, Nick Goodway (17/6/13)
Co-op Bank announces plan to plug £1.5bn hole Which? (17/6/13)
The Co-operative Bank and the challenge of finding co-op capital The Guardian, Andrew Bibby (13/6/13)
Co-op Bank seeks to fill £1.5bn capital hole Sky News (17/6/13)
Does Co-op Group deserve to keep control of Co-op Bank? BBC News, Robert Peston (9/7/13)
Questions
- Why did the Co-operative Bank move into financial trouble?
- What are the key characteristics of a Mutual? Are they disadvantages or advantages?
- What is a ‘bail-in’? Who will gain and who will lose?
- The Co-operative Bank will now be listed on the stock market. What does this mean?
- What are the advantages and disadvantages of floating a company on the stock market?
- Why are all banks required to hold capital to absorb losses?
The Prudential Regulation Authority is the new UK authority in charge of banking regulation and is part of the Bank of England. In a report published on 20/6/13, the PRA found that UK banks had a capital shortfall of £27.1 billion (see Chart 1 below for details) if they were to meet the 7% common equity tier 1 (CET1) ratio: one of the capital adequacy ratios (CARs) specified under the Basel III rules (see Rebuilding UK banks: not easy to do and Chart 2 below).
CET1 includes bank reserves and ordinary share capital (‘equities’). To derive the CET1 ratio, CET1 is expressed as a percentage of risk-weighted assets. As Economics for Business (6th ed) page 467 states:
Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. …Cash and government bonds have a risk factor of zero and are thus not included. Inter-bank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.
The data published by the PRA, based on end-2012 figures, show that the RBS group is responsible for around 50% of the capital shortfall, the Lloyds Banking Group around 32%, Barclays around 11%, the Co-operative around 5.5% and Nationwide the remaining 1.5%. HSBC, Santander and Standard Chartered met the 7% requirement. The PRA found that banks already were taking measures to raise £13.7bn, but this still leaves them requiring an additional £13.4 for current levels of lending.
So what can the banks do? They must either raise additional capital (the numerator in the CAR) or reduce their risk-weighted assets (the denominator). Banks hope to be able to raise additional capital. For example, Lloyds is planning to sell government securities and US mortgage-backed securities and hopes to have a CET1 ratio of around 10% by the end of 2013. Generally, the banks aim to raise the required level of capital through income generation, the sale of assets and restructuring, rather than from issuing new shares.
What both the Bank of England and the government hope is that banks do not respond by reducing lending. While that might enable them to meet the 7% ratio, it would have an undesirable dampening effect on the economy – just at a time when it is hoped that the economy is starting to recover. As Robert Peston states:
I understand that both Barclays and Nationwide feel a bit miffed about being forced to hit this tough so-called leverage ratio at this juncture, because they are rare in that they have been supporting economic recovery by increasing their net lending.
They now feel they are being penalised for doing what the government wants. So I would expect there to be something of a spat between government and regulators about all this.
Articles
Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Will Nationwide be forced to become a bank? BBC News, Robert Peston (4/7/13)
PRA news release and data
Prudential Regulation Authority (PRA) completes capital shortfall exercise with major UK banks and building societies Bank of England: Prudential Regulation Authority (20/6/13)
Questions
- Explain what are meant by the various Basel III capital adequacy requirements
- What are the banks which were identified as having a capital shortfall doing about it?
- Would it be desirable for banks to issue additional shares? Would this make the banks more secure?
- Would the raising of additional capital allow additional credit creation to take place? Explain.
- What other constraints are there on bank lending?
When people take out loans they typically do so to spend and with the UK economy in its current state, many would argue that this is a good thing. The ‘payday loan’ industry took advantage of the weak economy and the squeezed households in the UK and for the past few years, we have seen constant adverts that will appeal to many households. But, is the industry as competitive as the adverts would have us believe?
The OFT has criticized payday loan companies for competing not on costs, but on the speed of approval and using certain unapproved tactics as part of their advertising. The selling point of such companies is that you can have the money in a very short time period. However, the criticism is that this leads to loans being given to those who are unable to afford them. Key credit checks are not being done and with late night texts being sent to often financially vulnerable people, it is no wonder that complaints have been received. In a statement, the OFT said:
