An Update on Emerging Issues in Banking

Payday Lending

January 29, 2003 

Summary

Payday lending - among the highest risk subsets of subprime lending - is 

characterized by small-dollar, short-term, unsecured lending to borrowers typically 

experiencing cash flow difficulties.

Some insured depository institutions have failed to properly assess and control 

the risks associated with their payday lending programs. The consequences of 

deficiencies in risk management practices for payday lending programs can be 

severe.

The risks of payday lending are challenging for bankers and merit the continuing 

attention of depository institution supervisors. This issue of FYI provides 

additional information about payday lending.

What Are Payday Loans?

Payday loans are small-dollar, shortterm, unsecured loans that borrowers 

promise to repay out of their next 

paycheck or regular income payment. 

Payday loans are usually priced at a 

fixed-dollar fee, which represents the 

finance charge to the borrower. 

Because these loans have such short 

terms to maturity, the cost of 

borrowing, expressed as an annual 

percentage rate, can range from 300 

percent to 1,000 percent, or more. An 

example of a typical loan process for 

payday lending is described in the 

adjacent box.

How Payday Loans Work

In return for the small loan - usually 

less than $500 (See Chart 1) - the 

borrower provides the lender with a 

check or debit authorization for the 

amount of the loan plus the finance 

charge. The lender agrees to defer 

presentment of the check until the 

customer's next payday. At the next 

payday, the customer may redeem 

the check by paying the loan amount 

plus the finance charge, or the lender 

may cash the check. In some cases, 

the borrower may extend the loan by 

paying only the finance charge and 

writing a new check.
D

Who Are the Borrowers?

Typically, payday customers have cash flow difficulties and few, if any, lower-cost 

borrowing alternatives. Payday customers tend to be frequent users of payday 

advances, often choosing either to "roll over" their credits or to obtain additional 

subsequent extensions of credit (See Chart 2). This data indicates that the cash 

flow difficulties experienced by many payday customers are a long-term credit 

characteristic as opposed to a short-term temporary hardship.

D

A study by the Credit Research Center at Georgetown University's McDonough 

School of Business indicates that payday customers often rely on payday loans 

because they have either been turned down for other forms of credit or offered 

less credit than the amount for which they had applied. The study also indicates 

that payday advance customers frequently have other characteristics associated 

with credit problems or limited credit availability, including borrowing from a 

pawnshop in the past five years, filing for bankruptcy in the past five years, or 

making payments 60 or more days late on a mortgage or consumer debt in the 
last year.1 As a result of these characteristics, payday lending is generally 

characterized as a form of subprime lending. 

Who Makes Payday Loans?

At the beginning of the 1990s, payday lending was primarily the domain of 

smaller independent check cashing outlets and pawnshops that offered services 

related to check cashing. These firms specialized in making high-priced loans to 

borrowers with limited access to credit.

The number of payday lenders, however, has surged in recent years as more 

companies have been attracted by the higher fees earned on payday loans, as 

well as a high level of consumer demand for short-term, small denomination 

credit. New payday participants include large regional or national multi-service 

providers of payday loans, large regional or national monoline payday loan 

entities, and insured depository institutions. Although the number of known 

insured depository institutions involved in payday lending is small, third party 

payday lenders are actively seeking relationships with insured financial 

institutions.

Industry analysts estimate that the number of payday loan offices nationwide 

increased from less than 500 in the early 1990's to approximately 12,000 in 2002, 

with continued growth expected. The Community Financial Services Association 

of America, a trade group of the payday lending industry, estimated that payday 

lending activity in the United States during 2002 would reach about 180 million 

payday loans with a gross dollar volume of $45 billion.2

Insured Institutions and the Payday Market

Subprime lending in insured depository institutions is most commonly associated 

with auto, home equity, mortgage, and credit card lending. More recently, 

however, insured institutions have ventured into the payday lending arena.

Payday lending is not delineated in either bank Reports of Condition and Income 

or Thrift Financial Reports, but periodic surveys conducted by the FDIC indicate 

that relatively few insured depository institutions are currently involved in payday 

lending. However, there is no universal definition for payday lending, and some 

insured depository institutions have recently implemented overdraft lending 

programs that may, depending on the specifics of the program, exhibit 

characteristics similar to payday lending programs.

Insured depository institutions that are involved in payday lending have used 

various strategies to establish a presence in the market. Some have formed joint 

ventures with companies specializing in payday lending, while others have 

initiated payday lending programs internally. Insured institutions have extended 

loans directly to payday lenders, purchased payday loans from loan brokers, or 

lent to payday specialty lenders in the form of loan participations, warehouse 

lines, liquidity facilities, or dealer lines. While there is no evidence of an 

established asset-backed securities market for payday lending, some insured 

depository institutions have explored the possibility of securitizing and selling 

payday loans.

Risks Associated with Payday Lending

While the payday lending business presents banks with new growth opportunities, 

it also presents significant risks. To be sure, higher pricing on payday loans 

promises higher revenues and wider margins for lenders. However, there also are 

greater risks associated with payday lending. The credit risk associated with 

payday lending is significant, even when compared to other types of unsecured 
subprime lending such as credit card lending.

There are key differences between the underwriting methods used for subprime 

credit card lending and payday lending that renders payday lending among the 

highest risk subsets of subprime lending. Payday underwriting requirements are 

substantially less than those required by subprime credit card lenders who often 

supplement a prospective borrower's credit bureau report with such additional 

information as income, employment history, and the nature of prior credit 

problems. The prevailing underwriting criteria of most payday lenders require that 

consumers need proof only of a documented regular income stream, a personal 

checking account, and valid personal identification to receive a payday loan.

Credit quality data for specialty payday lending entities is lacking since most 

payday lenders are small, non-publicly traded firms. Review of publicly traded 

company reports indicates that some specialty payday lenders have recently 

recorded quarterly annualized net charge-off ratios as high as 83 percent,3 far 

higher than the typical annualized net charge-off ratio for subprime credit card 

lenders. Recent charge-off ratios for subprime lending institutions' credit card 

portfolios, while still high, typically do not exceed 20 percent. Higher default rates 

for payday loan portfolios indicate that loan loss reserves and capital levels that 

may be adequate for some other forms of subprime lending may not properly 

cover the greater risks associated with payday loans.

Depository institutions involved in payday lending also may enter arrangements 

with third parties to originate payday loans. These loans often involve fees and 

charges in excess of those the third party could otherwise charge under state law. 

Although federal banking statutes authorize insured depository institutions to 

"export" interest rates from states where the lender is located on loans made to 

borrowers residing outside the state, litigation involving the use of this authority by 

third-party payday lenders has recently increased. In addition, some suits also 

have alleged lender violations of various state and federal consumer protection 

laws in connection with these loans. Thus, participation in these arrangements 

may expose insured depository institutions to substantial legal and reputational 

risks. In addition, third-party arrangements may also pose additional operational 

risks, such as a heightened risk of transactional error or fraud.

Regulatory Implications

Recently, bank examinations have disclosed that a number of institutions involved 

in payday lending have failed to properly assess and control the risks associated 

with payday lending, and federal banking agencies have taken swift action to 

address the identified problems. For example, in September 2002, the FDIC 

entered into a formal enforcement action with one of its state nonmember 

institutions involved in payday lending. The FDIC required the institution, in part, 

to strengthen risk management practices associated with payday lending and to 

significantly augment capital to cover the greater risks associated with payday 

lending activities. The Office of the Comptroller of the Currency also has recently 

entered into formal agreements with several national banks, in some cases 

requiring the institutions to exit the payday lending business as a result of their 

failure to properly manage the attendant risks.

Depository institutions involved in payday lending should implement risk 

management programs that appropriately identify, measure, monitor, and control 

the risks associated with payday lending. The FDIC has recently developed draft 

guidelines for payday lending that would apply to all institutions under the FDIC's 

supervision that offer payday programs. The guidelines describe the FDIC's 

expectations for prudent risk management practices for payday lending activities, 

particularly with regard to capital, allowance for loan and lease losses, and loan 

classifications. The draft also addresses guidelines for recovery practices, income 

recognition, and managing risks associated with third-party relationships, as well 
as compliance with consumer protection laws. 

Conclusion

Payday lending presents insured depository institutions with significant risks. To 

be successful in payday lending, depository institutions must adequately identify, 

measure, monitor, and control the attendant risks. Depository institutions also 

must ensure that adequate management expertise and the appropriate level of 

capitalization are available, as well as programs that ensure compliance with 

consumer protection laws. Conversely, deficiencies in assessing and controlling 

the risks of payday lending can have serious consequences. Such deficiencies 

have surfaced at a number of insured institutions. 

1 Gary Elliehausen, Ph.D and Edward C. Lawrence, Ph.D, Payday Advance Credit in America: An Analysis of 

Customer Demand, April 2001.

2 Robert W. Snarr, Jr., No Cash 'til Payday: The Payday Lending Industry, Federal Reserve Bank of 

Philadelphia, CRA Compliance Corner, First Quarter 2002.

3 SNL Database.

About FYI

FYI is an electronic bulletin summarizing current information about the trends that 

are driving change in the banking industry, plus links to the wide array of other 

FDIC publications and data tools. 

Disclaimer 

The views expressed in FYI are those of the authors and do not necessarily reflect 

official positions of the Federal Deposit Insurance Corporation. Some of the 

information used in the preparation of this publication was obtained from publicly 

available sources that are considered reliable. However, the use of this 

information does not constitute an endorsement of its accuracy by the Federal 

Deposit Insurance Corporation. 

Last Updated 3/04/2004 
Chart 1

Almost All Payday Loans Amount to Less Than $500 in Size

Size of most

recent new advance 

Percent of

Respondents 

$100 or less 7.0

$101-200 27.3

$201-300 45.4

$301-400 8.9

$401-500 9.2

More than $500 2.2

Source: Elliehausen and Lawrence (2001)

Chart 2

Payday Borrowers Tend to be Repeat Customers

Number of payday loans

per borrower over a

12-month period

Percent of

Respondents 

Over 25 4%

20 to 25 12%

16 to 19 13%

11 to 15 18%

6 to 10 26%

1 to 5 27%

Source: Wisconsin Department of Financial Institutions