Comment: In support of community-based lending

Payday lenders claim that their ideal customer is in full-time employment but, facing a sudden need for access to money, is relatively unconcerned about the cost of borrowing. By charging 1 per cent interest a day on a typical loan of £250 repaid after two weeks, payday lenders probably earn about £35. This is similar to the cost of setting up an overdraft with a high street bank.

However, payday loans often end up costing much more than this. The OFT believes that half of all loans are not repaid when they are due, but are instead rolled over for another month. The charge for credit on that £250 will then increase to about £150; a good deal for the lender – if it can collect the money. Payday lenders claim that high interest rates allow them to screen out bad credit risks and also to offset the risk of customer default.

Payday lenders are treated like the pit-bull terriers of consumer finance. The knee-jerk reaction is to ban them. Credit unions, like puppies, have for many years turned politicians dewy eyed, because they might be part of a kinder, gentler society.

It might be more accurate to say that politicians like the concept of credit unions. They are small, serve a specific community, can be managed by volunteers and need much less capital to set up than other providers of financial services. They provide instant access savings and consumer credit to their members, and can work with sections of the population who would otherwise struggle to get access to these financial services.

The basic business of a credit union is quite simple. It has to mobilise members’ savings. It then makes loans from this pot of savings to its members. So long as members borrow enough from the shared pot, and repay their loans, the business is profitable. The simple fact is that the charge for credit on a £1,000 credit union loan, repaid over a year, is often less than on a £250 payday loan, repaid in full after four weeks. So, why would anyone use a payday lender when a credit union’s loans are so much cheaper?

Like high street banks, credit unions are not interested in making very short-term loans. More importantly, though, credit unions are membership based and rely on an ongoing relationship with their members to make lending decisions.

Every credit union’s potential membership pool is defined by a “common bond”, a relationship that links the credit union’s members. Employment and residency are the usual qualifications.

Credit union procedures ration credit. Especially in smaller credit unions, members have to save regularly for three months before being able to apply for a loan, and the maximum amount that any member can borrow is usually a fixed (relatively low) multiple of their savings. New members who save for three months and then borrow three times their savings will be expected to repay their loan in ten months, while still making a modest contribution to their savings.

Requirements that members should be in good standing before applying for a loan might seem very old-fashioned. Payday lenders simply treat credit as a commodity traded on a market. They work out repayment probabilities using statistical data. They claim to offer an immediate response to sudden needs. Credit unions work on the basis that members will plan their need for credit. They allow members to smooth consumption, so that they can choose when to make large purchases without running down savings.

The ongoing relationships that underlie credit union lending enable them to offer access to credit to people who might otherwise be considered very high risk. This is why credit unions are admired by politicians: supporting them shows support for combating poverty.

Public funding has been dangled in front of credit unions to encourage them to take on Herculean tasks – in the past ten years, they have been asked to tackle financial exclusion, encourage business formation in areas of social deprivation, be payment agents for social benefits and, most recently, to take on payday lenders.

Every public intervention that identifies credit unions with combating social exclusion carries a risk of causing them serious reputational damage. Credit unions often complain that this policy defines them as the “poor bank”, as if they exist only for people who cannot use other financial service providers.

Reflecting successive governments’ policies, some credit unions have been formed with common bonds drawn so that their members typically have very low incomes. They generate a small savings pot from their members and lending never really takes off because so many members would struggle to make regular payments. When they do lend, approval and monitoring costs are high. The result is a group of credit unions struggling to meet half of their operating costs from loan income.

Using credit unions as an anti-poverty tool treats one characteristic of a successful credit union as its main purpose. Using public support to foster credit unions that can never be viable damages all credit unions. The substantial funding that the Department for Work and Pensions has just committed does just that. Its modelling assumes that credit unions will target the poorest third of the population.

Instead, public policy should recognise that credit unions offer well-defined services, based on offering a better deal for members than conventional financial service providers.

Most successful credit unions draw their members from a much wider community than “poverty” credit unions. Often defined by a “live-or-work” common bond, they quickly build a large savings pot by persuading local employers to offer payroll deduction. With members in full-time employment, lending risk is reduced substantially.

A workplace credit union should be very accessible to members. Payroll deduction is important but, increasingly, credit unions have to be able to offer access to services through web-based platforms, with lower-risk lending decisions being made very quickly. Slightly lower interest rates will not be enough for credit unions to compete successfully in a crowded market.

The largest credit unions in Scotland could now become community banks, challenging the extreme concentration of high street banking. They would take a lead in widening the range of services available to members. By forming a central board – a credit union for credit unions – to manage this service provision, and provide new credit unions with access to capital, expansion across the sector would be internally led, not externally driven.

A central board could develop a “template” for the creation of more, soundly-based, credit unions in the years ahead. It should be able to enter into relationship with other organisations with similar interests – those who can provide assistance via skilled manpower, properties and even some capital. Churches, trade unions and debt advisers are obvious candidates.

Such a policy would be friendly to credit unions, without trying to make them take on impossible tasks. While not using credit unions to eliminate payday lending directly, by making regular saving as easy as possible, and lending responsibly, credit unions have an important role to play in improving financial literacy.

• Dr Robbie Mochrie is a senior lecturer in economics at Heriot Watt University. Jeremy Peat is director of the David Hume  Institute