On the matter of public policy, it’s always wise to look beyond its visible effects. In particular, what’s not happening as a consequence of what on the surface perhaps reads as helpful policy?
Questions like these logically come to mind in the aftermath of interest-rate caps implemented by the state of Illinois in 2021. Eager to protect those with the least from paying nosebleed rates of interest on unsecured cash loans, legislators passed a law that put a ceiling on the rate of interest that could be charged on those loans of 36%.
Looked at solely in surface terms, some might conclude that the state’s legislators did well by the people. Interest costs can add up, and the fact that they can is particularly burdensome for the poor. A majority of Illinoisans supported the legislation, but their support arguably signaled a failure to look beyond the visible effects of price controls. Thankfully economists J. Brandon Bolen (Mississippi College), Gregory Elliehausen (Board of Governors, Fed), and Thomas Miller (Mississippi State) chose to dig quite a bit deeper into the unseen of perhaps well-meaning policy.
They set out to document the effects on subprime and deep subprime borrowers with parallel tracking of lending in the capped state of Illinois versus the state of Missouri, an uncapped neighbor, and as such, “an appropriate counterfactual.” While they led with the assumption that “any price ceiling” would lead to shortages, the researchers tracked lending in the neighboring states for four consecutive quarters with an eye on seeing if theory matched up with reality.
Up front, theory lived up to reality. The cap’s imposition resulted in reduced lending in Illinois, and in particular for deep subprime, minority borrowers. At the same time, supporters of rate caps would no doubt find statistical outcomes in the research that at least “visibly” support the caps.
For one, Bolen et al found that the average small-dollar loan size in Illinois post-cap actually rose 37%. This fact can’t be ignored in light of the initial supposition that credit shortages would be the consequence of rate ceilings. At the same time, what’s not ignored calls for readers to similarly not ignore what a substantial increase in lending perhaps glosses over.
Indeed, money isn’t just loaned. All lenders incur administrative costs related to vetting potential borrowers. The researchers had to consider this in consideration of the increase of loan size, only for the latter to make sense after the rate cap’s imposition. Bolen, Elliehausen and Miller concluded that the documented increase in average loan size was “consistent with the notion that a larger loan size is needed to make small loans profitable at a maximum rate of 36 percent.”
Stop and think about what this at least theoretically implies for subprime and deep subprime borrowers. It signals that the riskiest of them will not rate credit in a capped environment, while borrowers representing reduced risk will secure bigger loans. Ok, but does theory yet again match up with reality? It turns out it does.
While loan size increased, Bolen et al found that the cap “decreased the number of loans to subprime borrowers by 30 percent.” As for black and Hispanic borrowers, the economists found that 60 percent of black borrowers and over 70 percent of Hispanics in search of small-dollar credit have subsequently “been unable to borrow money when they needed it.” In other words, lending went up in total, albeit to a narrower range of borrowers.
To which supporters of the legislation might respond that per the study, lending still increased in Illinois, thus calling into the question the overarching theory. And the questions wouldn’t just be related to loan size. The researchers also found that loan growth in Illinois increased 14 percent in the four quarters after cap’s imposition. 14 percent on its face perhaps glares at first glance; that is, until we bring uncapped Missouri into the discussion. The Show Me state offers context.
Of note, while loan growth was once again 14 percent in Illinois, it was 26 percent in Missouri. If we make the logical assumption that loan growth would reflect economic growth, unsecured loans in interest-rate capped Illinois lagged what took place in neighboring Missouri. And while lending that’s not happening is the proverbial unseen, it looms large. Bolen, Elliehausen and Miller calculate that 19,176 loans were not made that otherwise would have been made absent the rate ceiling.
Instead, and as previously touched on, larger loans were made to fewer borrowers. In Illinois the average size of unsecured loans was $8,317 over the four quarters post-cap, which amounted to a 33% ($2,072) increase in loan size. Contrast that with Missouri where the average loan size was $5,093 amid an average increase of roughly 10%, or $478.
All of which supports the initial assumptions made by Bolen et al. They suspected that shortages would emerge from the rate caps, only for them to emerge. In their words, “imposing the interest rate cap in Illinois limited credit access to high-risk borrowers.” And it did as evidenced by a slower increase in loan growth in concert with substantial increases in loan size to reflect the migration away from high-risk borrowers.
It’s all a reminder of how crucial the invisible is on the matter of policy. Applied to Illinois, arguably the most damning aspect of its rate cap has been what hasn’t taken place in response.