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Tackling the Loan Sharks: an Ethical Alternative

  • Credit unions must be allowed to charge more and take bigger deposits from business if they are to provide the antidote to high-interest lenders
  • To be effective charities, they must first be effective financial institutions, says Civitas report
  • The government’s reforms do not go far enough and will not remove the obstacles to growth in the credit union sector

Burdensome regulation is preventing credit unions providing a widespread affordable alternative to loan sharks, a report by the independent Westminster think tank Civitas warns today.

Restrictions on their fees and the size of deposits are also curbing the role the non-profit organisations could play in supporting finance-starved small business, it says.

Ministers are legislating to raise the cap on the monthly interest charged by the ethical lenders from 2% to 3%, but this will not be enough to facilitate the expansion needed.

The government must give credit unions greater freedom so that they can become a significant force for good in the financial sector – taking on payday lenders and meeting the needs high street banks fail to address.

Civitas researcher Joseph Wright recommends that, if ministers are serious about helping credit unions become the “antidote” to high-interest lenders, they should:

• Allow credit unions to not only raise their interest charges to 3%, but pass on the processing fee – typically £8 – to the consumer in full.

• Remove the £10,000 limit on deposits for businesses that wish to invest more than that with credit unions.

Together these recommendations would enable credit unions to offer a wider range of products to a greater number of people by enabling them to operate more cost-effectively and attract more and bigger deposits.

“To be effective charities, they must first be effective financial institutions,” Wright says.

Even with the additional interest and processing charges, credit union loans would remain much cheaper than most of the products currently on offer. This would enable them to offer a much-needed alternative to payday lenders, who have expanded enormously in recent years despite extortionate rates of interest.

In ‘Credit Unions: A Solution to Poor Bank Lending?’, Wright explores the ways in which credit unions are prevented from playing a bigger role in the financial services market.

As part of a drive to encourage alternative sources of finance, the Department for Work and Pensions has been developing a Credit Union Expansion Project (CUEP) to speed up development in the sector over the coming years. Welfare Reform Minister David Freud said: has described credit unions as “the antidote to predatory loan sharks or high-interest lenders”.

But, today’s report argues, the project is limited and will not remove the biggest barriers to credit unions becoming a recognisable force. “That real expansion will require further empowerment of credit unions to tailor their lending models to their needs.”

Crucially, credit unions need to be able to attract more depositors and, while the ethical dimension of credit unions is a compelling attraction for many people, the wider consumer market needs more incentives, such as easy access to money and quick transfers. Credit unions therefore need to offer a similar range of products to mainstream financial services. Without a competitive current account package, the credit union sector stands no chance of competing in the market.

The current cap on interest at 2% does not allow even the most cost effective credit unions to break even on smaller loans. This cap includes a prohibition on service charges for loans and excludes consideration of the operational costs involved, so credit unions make a loss on many smaller, short-term loans – and consequently often avoid issuing them.

The DWP announced last week it would legislate for a new cap of 3%. But this still provides only a poor incentive for credit unions to push the product. Today’s report suggests credit unions should also be allowed to pass on the origination costs for a loan, usually about £8 to the consumer in full. Even with this added cost, short term loans would remain very affordable and far cheaper than any of those currently offered.

“Ultimately, credit unions cannot be expected to combat payday lenders if they are continually forced to make a negative or non-existent return on the same loans,” Wright argues.

“Credit unions cannot be expected to be a real alternative to payday lenders until they are equipped to offer short-term loans on an economical basis.”

Branching out into business lending could also significantly increase revenues, bringing greater returns on loans and larger deposits for on-lending. Currently, however, deposits are limited to £10,000 or 1.5% of the shareholding of one member – and a business, however large, counts as only one member.

“A cap is important in acting as a safeguard for smaller credit unions against more risky lending, but for larger and more capable credit unions, such a low cap will be a considerable barrier in the future. It removes the choice of entering into business with larger corporations from the individual credit union, which is in a far better position to understand its own financial institutions.”

A promotional campaign to raise awareness of credit union services is also necessary. Up to 7 million people use sources of high cost credit like home credit and the payday lending market is now worth more than £2 billion. But there is very low recognition of credit unions: only 13% of the more than 4,500 people consulted by the DWP had heard of them before. However, more than half said they would like to try them.

“A stronger credit union sector will help to bolster the financial market against future market failure and it is important to do this while the impetus is still there.

“A sensible balance needs to be found for the interest rate cap, where credit unions still offer cheap levels of credit without suffering losses that may ultimately weaken smaller credit unions. Only this, along with a sophisticated promotional campaign to educate people about credit unions will enable them to be the antidote to payday lenders.”

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