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"Credit Where It's Due"--A Commentary by Prof. Richard Brooks

(This essay was originally published in the April 12, 2004, issue of Forbes magazine.)

Credit Where It's Due
By Richard Brooks, associate professor of law

In praise of pawnshops.

Don't outlaw pawnshops and check cashers; insist they report clients' good credit.

Low-income consumers in America's urban areas do a lot of buying on credit using so-called fringe lenders: pawnshops, rent-to-own stores, check-cashing outlets and other noncharter lenders offering such services as payday or title loans and tax refund anticipation loans. Shops offering these high-cost short-term credit options and basic banking services line the streets.

Informal credit markets are nothing new. Buddhist monasteries ran pawnshops in China as far back as the fifth century, and the presence of pawnbrokers in ancient Greece and the Roman Empire is also well documented. In the U.S. of the early 1900s, retailers and, to a lesser extent, pawnshops were the primary sources of consumer credit. Eventually, locally headquartered banks and branch offices of larger depositories joined the urban credit mix. But beginning around the second half of the 20th century many large credit institutions left U.S. cities as part of a more general flight of urban wealth. The resulting concentration of poverty and absence of banks promoted the development of credit transactions tailored to the urban poor.

As the fringe credit market has grown, so too has the steady drumbeat of criticism and calls to restrict or do away with fringe credit transactions. At the moment, legislators in at least a dozen states, including California and Illinois, are considering laws that would constrain fringe lenders. Just days after Ralph Nader announced his presidential candidacy, he railed in an interview against "economic crimes in the ghetto," singling out "predatory lending, payday loans [and] rent-to-own rackets."

The calls for reform and regulation are not unreasonable, but if we restrict fringe credit transactions or do away with them altogether, vast numbers of low-income borrowers would have no access to credit at all. There is another way: Simply require or encourage fringe creditors to report on their borrowers' credit records. As it stands now, fringe lenders deny their customers the most basic prerequisite for access to traditional credit markets: portable evidence of creditworthiness in the form of a credit history.

A credit history is the primary mechanism that conventional banks use to assure repayment of consumer loans, from small credit card advances to mortgages. Banks use credit histories to screen for high default risks and to discourage defaults by an explicit threat to damage the borrower's credit record if he falls behind.

Fringe credit transactions, on the other hand, neither rely on nor contribute to general measures of creditworthiness. A principal effect of this is to undermine banks' repayment threat, which discourages them from making loans to fringe-market consumers. Since banks are less likely to lend to them, these customers have less incentive to develop good credit records, leading to their being screened out more often at the application stage. The fringe credit market in effect bars conventional creditors from lower-income markets.

With proper reporting, low-income borrowers could establish favorable credit records, which would make them more attractive to traditional lenders. Studies have found that a significant portion of fringe borrowers have solid repayment behavior. As a consequence, "good" borrowers would have the option to leave the fringe market for the lower borrowing rates of the traditional retail credit market.

As the more creditworthy borrowers depart, of course, the remaining, riskier fringe customers would be charged higher interest rates. But at least they would still have access to credit. These riskier borrowers are currently being subsidized by conscientious repayers who are trapped in the current system. It is a fine social objective to subsidize the borrowing of poor people with risky credit portfolios, but it seems patently unfair to make other poor people with good credit practices foot the bill.

To be sure, tracking, maintaining and reporting repayment behavior are direct expenses that fringe creditors will pass on, at least in part, to their consumers. Nevertheless, credit reporting of fringe transactions could benefit millions of low-income Americans aspiring to someday finance a home, a car and an education for their children at the same low rates that most Americans have enjoyed for the last few years.