The drivers of illegal lending

In July, we reflected on new evidence looking at people’s experience of using illegal lenders.  Whilst recognising that increasing access to affordable credit could benefit people who may otherwise use illegal lenders, we warned that recent estimates concerning the extent of illegal lending may be unreliable, as cost-of-living pressures and over-indebtedness were likely to be the main drivers.  Policy responses to counter illegal lending therefore needed greater focus on these.

Today, we are releasing a report of the findings from our secondary analysis of the Financial Conduct Authority’s Financial Lives Survey of 2020. The safeguarded data for the study was made available following an application to the Consumer Data Research Centre.

Our study finds that undertaking short-term work, such as driving for Uber or working for Deliveroo; having only low or no qualifications; and having a long-term health condition which significantly limits daily activities, all increase the probability of using illegal lenders.

But, after accounting for these demographic factors, financial pressures play a significant role. People experiencing their legal debts as a heavy burden or struggling with repayments are more likely to turn to illegal lenders.  Between 1 in every 100 to 160 of people in this position are estimated to be at risk.

The risk of using an illegal lender is, however, far greater if people have borrowed from a legal payday or door-to-door moneylender (‘home credit’) in the past 12 months.  According to our analysis around 1 in every 25 payday borrowers, and 1 in every 9 home credit borrowers are likely to have ended up borrowing from illegal lenders.

Our study indicates that whilst cost-of-living pressures are likely to have increased illegal lending use in recent years, the reduction in payday and home credit lending over the same period may have mitigated against this.  Often it is people who have borrowed from these legal high-cost lenders on a repeated basis whose financial situations become desperate enough for them to turn to loan sharks.  We have previously reported this dynamic in our 2009 study of Japan, where illegal lending use grew alongside an expansion of legal high-cost credit, rather than because of a ‘credit vacuum’.  The subsequent capping of charges and the introduction of responsible lending requirements, together with higher penalties for illegal lending, resulted in a reduction.

It is notable that the likelihood of using an illegal lender is by far the greatest amongst home credit borrowers, as home credit was specifically exempted from the total cost cap imposed on other forms of high-cost credit in 2015.

Allowing legal, high-cost credit to expand, is therefore no solution to the problem, and any attempt to row back on responsible lending requirements by such lenders needs to be firmly resisted. For example, the high-cost lender Lending Stream has recently argued that the current regulatory environment is too “hostile” to them and that “the doors are thrown wide open for illegal lending.”  This reveals the danger of making unreliable estimates of the scale of illegal lending (see below) as it creates fertile ground for such lenders to claim they are part of the solution when this is not the case.

Importantly, an expansion of affordable credit as many are calling for – whilst it would be welcome – is also unlikely to be sufficient on its own to prevent a growth in illegal lending.  Struggling with bills and existing credit repayments is a stronger driver of illegal lending use than being declined for credit, implying that direct measures to address the cost-of-living crisis and over-indebtedness would be more successful than providing additional lines of credit.

What is needed to produce a reliable estimate?

Recent estimates of illegal lending have varied widely.  Last year the Centre for Social Justice (CSJ) estimated that 1.08 million (2.5% of the population) were borrowing from ‘loan sharks’.   This is over 800,000 more than was estimated by the FCA’s 2020 Financial Lives survey, and the FCA’s latest survey does not indicate any increase in that figure.

Given the sensitive nature of the subject, some under-reporting of use is likely. But it is likely that the methodologies employed by smaller scale surveys, such as the CSJ’s, also play a part.  Such surveys are commonly weighted by factors including age, income, and housing tenure, but could nevertheless over-represent clusters of the groups most likely to use illegal lenders.

We therefore recommend that future surveys undertake more sophisticated extrapolation strategies which include weighting for the demographic factors identified by our analysis as well as in respect of financial pressures and prior use of legal, high-cost, credit.

However, it is important to note that our study also points to other, currently unstudied, factors playing a potentially large role in the decision making of borrowers turning to illegal lenders.  The supply of illegal lending could be as important as the drivers of demand. It is possible that the decision to use an illegal lender is highly contingent on the opportunity to do so.   For two potential borrowers with the same demographics, and facing similar financial pressures, the critical factor could be whether they know an illegal lender or have a mutual acquaintance who does.  Future surveys could therefore usefully ask respondents whether they know of any illegal lenders as well as whether they have borrowed from one.

Download the full report here.

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