RATE CAPS LEAVE BORROWERS BEHIND

The following information was released by the American Financial Services Association (AFSA):

A recent post on the Federal Reserve Bank of New York's Liberty Street Economics blog offers a sobering look at how interest rate caps reshape the consumer lending market, often in ways their proponents may not intend.

The analysis, drawn from a New York Fed Staff Report, examines three states (Illinois, South Dakota, and North Dakota) that enacted 36 percent rate caps between 2016 and 2022. Using data from the New York Fed Consumer Credit Panel (CCP) and Equifax covering more than 35 million borrowers, the authors trace where credit goes after a cap takes effect.

The story has two parts. In a companion post, which AFSA commented on here, the authors showed that rate caps lead lenders to limit the flow of credit to the riskiest borrowers whose loans previously priced above the cap. The latest post answers the natural follow-up question: what happens to the funds that these high-risk borrowers can no longer access?

The answer is reallocation. Rather than simply exiting the market altogether, many lenders shift their focus toward somewhat safer borrowers for whom the cap does not bind. The data show increased borrowing among consumers in the third through fifth risk score deciles, a group that includes borrowers near the traditional subprime-prime cutoff of roughly 620. Notably, this increase in lending to moderately creditworthy borrowers largely offsets the decline at the bottom of the distribution, so aggregate borrowing falls only marginally.

This pattern is not new. The authors point to historical and international precedent, including 19th century evidence and a study of usury limits in Peru, both showing credit migrating toward safer, more established borrowers. Even Adam Smith, they note, favored usury limits so that credit would flow toward more reliable borrowers.

The takeaway for the consumer finance industry is a familiar one, now backed by fresh modern evidence: rate caps involve tradeoffs. Some borrowers benefit from newly available credit, while the most vulnerable, those the caps are often designed to protect, find themselves with fewer options. Whether that reallocation was the goal of policymakers, the authors observe, remains an open question.