Since You Asked

That’s a lot of Wonga for a business loan!

‘Wonga, the online lender that charges annual interest rates of 4,000 per cent on short-term loans, has launched a service for cash-strapped small businesses that offers to make credit available in as little as 15 minutes.’

Financial Times, May 7

Wow.

The chief executive of Wonga describes it as a “premium service”.

I’ll say. Are they planning to charge 4,000 per cent to small businesses, too?

Apparently not. Their maximum rate is 2 per cent a week, which sounds modest but compounds to about 280 per cent a year. Sharlene Goff, the FT’s retail banking correspondent, reckoned that the largest loan (£10,000) for the longest term (a year) would rack up almost £11,000 in charges. All of this is some way short of 4,000 per cent but it’s not cheap.

How can they possibly get away with that?

You mean, why doesn’t someone put them in prison?

Well – yes, why not?

Because there are no caps on lending rates in the UK. If you treat people fairly and are transparent about your rates, you can charge whatever you like.

That raises another question: how can they possibly find anybody willing to pay that kind of money?

Assuming they do – which remains to be seen – I think there are two possible explanations. The first is that customers are idiots. The second is that some customers badly need the money and have no alternative funders.

Start with hypothesis one.

The thing that makes me nervous here is the fact that the newspaper stories all report that Wonga will release funds in as little as 15 minutes. Surely this is only a selling point for the extremely impulsive or the extremely shortsighted. Most small businesses would be just fine with a lender who took a few days to release funds. We also know, thanks to research from economists such as Annamaria Lusardi and Jonathan Zinman, that a lot of people are financially illiterate and have poor intuitions about the costs of compound interest. You might hope that most company directors would know better, but presumably there will be some exceptions to that rule.

And what about the alternative view: that a loan at an annual interest rate of several hundred per cent or more might be a good business proposition for the borrower?

First, remember that an annual percentage rate might not be the best way to evaluate the cost of a small, short-term loan. If I need to borrow money for a few weeks as a bridging loan, the lender has to bear certain costs and risks – but even a small charge would balloon into a huge annual interest rate because the loan was so brief.

In other words, charges of a few quid might look huge expressed as an APR.

In some circumstances, yes. Remember, if you stumble into an unauthorised overdraft from a high street bank you may end up paying charges of which a payday lender can only dream. I’ve written before about a randomised trial conducted by Dean Karlan, economist, and Mr Zinman on the impacts of loans at 200 per cent APR in South Africa; surprisingly, such loans seem to help borrowers because they allow them to buy work clothes or transport and so actually get or keep a job. It’s not hard to imagine situations where a few grand for a couple of months could keep afloat a fundamentally sound business with cash-flow problems.

Fair enough, but if there are so many fundamentally sound businesses with cash-flow problems, why aren’t banks lending to them?

You’re assuming that they aren’t and I have to say you may be right. The Bank of England’s latest “Trends in Lending” report finds that the stock of lending to small businesses is shrinking fast.

Perhaps because small businesses are paying off their debts and don’t want to borrow?

That’s logically possible, but the cost of borrowing is also rising. I think it’s safe to say that the banks aren’t keen to lend, either because of their own funding costs or because they are nervous about getting paid back.

So Wonga is filling a market niche?

I think Wonga’s main niche is likely to remain cash-strapped, naive consumers, but the publicity this business-lending launch has earned them will do no harm. I can’t get too excited about payday loans for businesses: I am more worried about the fact that they are a symptom of very tough times.

Also published at ft.com.

12th of May, 2012Since You Asked • Comments off