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Payday lending: fixing a broken market
About ACCA
This report analyses online payday
lending business models and
outlines a proposed framework to
be used to determine the level for
the cap on the cost of credit, which
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2 2014Payday lending: fixing a broken market Sarah Beddows, Independent Consultant and Mick McAteer, Financial Inclusion Centre.
ACKNOWLEDGEMENTS Thanks to Robin Jarvis, Special Adviser, ACCA and Professor of Accounting at Brunel University. 4
Contents 1. Introduction 7 2. The structure of the UK payday lending market 10 3. Literature review 12 4. Data sources 13 5. Customer Acquisition Cost 15 6. Default 25 7. Rollovers and refinancing 40 8. Intensity of use 46 9. Market failure 54 10. Framework for setting the Rate Cap 60 11. Conclusion 65 12. Technical appendix 66 References 69 PAYDAY LENDING: FIXING A BROKEN MARKET 5
6
1. Introduction
In 2012 over 12m short-term cash Figure 1.1: Total UK originations (billions)
advance or ‘payday’ loans1 were
arranged in the UK. A total of £3.7bn-
worth of credit was extended in this way
and UK borrowers paid over £900m in 4 £3.709
interest and charges.2 The lack of
appropriate regulation, post-crisis £3.016
3
constrictions in traditional forms of
unsecured lending and a large
population struggling with falling real 2 £1.902
incomes have combined to create an
£1.200
attractive market for payday loans in the 1 £0.780
UK. As we can see in Figure 1.1, growth £0.508
since 2006 has been explosive. £0.330
0
A payday loan is a small, short-term 2006 2007 2008 2009 2010 2011 2012
unsecured loan with both principal and
interest scheduled to be repaid on a Source: 2006 and 2009 figures from Burton 2010; 2011 and 2012 estimates based on lenders’ financial
single date. The average payday loan is statements. All other years are interpolated.4
currently around £270 for 30 days
(Office of Fair Trading 2013b). Payday
loans represent one of the highest-cost
forms of credit available, interest
charges range from £15 to £35 per £100
borrowed for 30 days, equivalent to
between 448% and 3,752% Annual
Percentage Rate (APR). Late payment
and transmission fees further increase
the Total Cost of Credit (TCC)
associated with these small loans.
Payday loans are the fastest way to
obtain credit: first-time, store-based
loans take about an hour to process
(BBC One 2012), first-time online loans
can take as little as 15 minutes,3 and
repeat loans are even faster to obtain.
Online lenders are open 24 hours a day
seven days a week.
1. The generic term ‘payday loan’ is used
throughout to refer both to traditional payday
loans and short-term cash advance loans.
2. Estimates based on lenders’ financial
statements and Office of Fair Trading (2011a)
estimates of market shares.
4. In their Payday Lending Compliance Review Final Report, The Office of Fair Trading (2013b) appear to
3. Online lenders’ own estimates from their have based their estimate of the size of the UK payday lending market of £2.0bn to £2.2bn on ‘initial loans’
websites. only. We include all loans in order to allow comparison between years.
PAYDAY LENDING: FIXING A BROKEN MARKET 7Those in favour of payday loans typically Credit Act and other legislation’ (Office SMALL LOANS – HIGH CHARGES
advance one of four main arguments in of Fair Trading 2013b: 2) and that
support of the product. First, the high ‘Payday lenders are also not meeting The payday lending industry’s principal
interest rates charged simply reflect the the standards set out in our defence of the high interest rates
high costs involved in providing small ‘Irresponsible Lending Guidance, charged is that they simply reflect the
sum, short term loans. Second, the low (Office of Fair Trading 2013b: 2) The high costs involved in providing small
absolute cost of each loan means they entire industry has now been referred to sum, short-term loans (see, for example,
are often cheaper than alternative the Competition Commission and the Booth 2012). This implies that their
sources of short term credit such as Banking Reform Bill will confer a ‘duty pricing policy is based on a cost plus
unauthorised overdrafts. Third, the to cap interest rates’ (HM Treasury 2013) pricing methodology.
‘bullet’ structure (principal and interest on the Financial Conduct Authority
repaid on a single date) of payday loans (FCA). The Consumer Finance Association
makes the product simple to (CFA) currently has this Industry Briefing
understand and means prolonged The level and form of this new interest regarding APRs on its website: ‘the
indebtedness is less likely. And fourth, rate cap is yet to be determined. There costs of lending this way are high. The
lenders have a clear incentive to lend are questions, however, as to whether a cost of lending someone a small
responsibly: they want to get their cap on APR alone will be sufficient to amount, eg £200, is the same as lending
money back. For its supporters, a make the payday lending market a larger amount, eg £5000. It entails the
payday loan is a useful income- function well for borrowers. In same credit checks, bank verification
smoothing tool with clearly stated particular, the potential for lenders to checks, fraud prevention checks and
terms. derive revenue from interest charges regulatory requirements including
and from default fees and interest anti-money laundering, mental capacity
On the other hand, critics assert that accrued post-default means a cap on and responsible lending checks.
the very high interest rates charged are the TCC may well be more appropriate. Underwriting 25 × £200 loans (£5,000
predatory by definition (see, for total) clearly increases the cost to the
example, Mendick 2012). They argue The purpose of this report is to develop lender 25 fold.’ (Consumer Finance
that the bullet style of repayment makes a detailed understanding of the Association 2013b)
payday loans very hard to repay and business models driving UK payday
means borrowers are often sucked into lending in order to inform the debate Similarly, Wonga.com’s founder and
a ‘debt spiral’: unable to pay back their about the level and structure of the new former CEO Errol Damelin commented
first loan they take another loan (called interest rate cap and to examine which that ‘We do small, short-term things,
‘rolling over’, ‘extending’, ‘refinancing’ other regulatory interventions may be and the cost of delivering that service is
or ‘renewing’), incurring more and more necessary to create a small-sum lending high’ (Shaw 2011). The CFA further
charges. And they are concerned that market which allows lenders to innovate argues ‘Set the rate (cap) too low and
the increasing numbers of borrowers and also delivers good outcomes for payday lenders will no longer be able to
reporting problems repaying such borrowers. This report is designed to afford the high operational costs ...
loans5 constitutes clear evidence of support the ongoing work of the thereby putting them out of business’
irresponsible lending. Competition Commission (CC) and the (Consumer Finance Association 2013b).
FCA, but it may also be of interest to
The industry’s own regulator, the Office consumer groups and, ultimately, to Determining how much ‘headroom’ – in
of Fair Trading (OFT), has found that investors. the form of profit and costs which could
‘The payday loans market is not working be reduced while still providing loans –
well for many consumers. Our review exists in prevailing business models is
has found evidence of widespread therefore now critically important in the
non-compliance with the Consumer determination of a cap that is fair both
to borrowers and lenders.
5. For example, the number of people contacting
the Consumer Credit Counselling Service (CCCS;
now called ‘StepChange’) about payday debt
more than doubled between 2010 and 2011 (Hall
2012).
8This report will examine in detail the We explore the potential for adverse Could a new framework be devised to
following areas. selection and product design to determine the level of the new rate
contribute to high levels of defaults. cap?
Do charges faced by borrowers really We outline a proposed framework for
correlate to the operating costs How profitable are rollovers? determining the level of the new rate
incurred by lenders? What are the We extend the simple model using a cap. We argue that the low elasticity of
costs involved in providing online theoretical distribution of rollovers demand exhibited by existing payday
payday loans? based on that found in the OFT’s borrowers makes a ‘cost plus’ approach
To answer these questions we construct Payday Lending Compliance Review to pricing inappropriate for this market.
a simple model using cost information Final Report (Office of Fair Trading Building on the work of the National
taken from Cash America’s financial 2013b) and find that rollovers are Consumer Law Center in the US we
statements. We argue that the level and disproportionately profitable – argue that affordability should be of
structure of advertising and marketing accounting for 200% of our model primary importance in setting the new
costs exceed income on first-time loans. business’s profits. (Rollovers are loan rate cap and that the patterns of
If this is the case then online business extensions. They are fully defined and repayment and default experienced by
models are reliant on repeat lending for discussed at the beginning of Chapter 7.) existing payday borrowers can help
their profitability. inform our thinking about affordability.
Has innovation in the form of
What proportion of lenders’ revenues charging interest on a daily basis
is absorbed by losses due to default? actually resulted in shorter, cheaper
We examine the relative riskiness of loans for borrowers?
online and retail payday lending in We construct another simple model
the UK. using revenues earned, average loan
sizes and average loan lengths taken
We develop a simple methodology to from Wonga.com’s 2011 financial
estimate the numbers of loans statements in order to examine the
borrowers have difficulty repaying, possible distributions of loan sizes and
using the percentage of revenues lengths.
lenders are willing to lose to defaults. It
is not surprising that these estimates Why is competition not working for
are broadly consistent with the OFT’s consumers and which policy options
finding that ‘...around a third of loans could improve the functioning of the
are repaid late or not at all.’ (Office of payday lending market?
Fair Trading 2013b: 2) We examine market failure and argue
that there is a risk that multiple loans
We develop an understanding of the allow lenders to finance each others’
distribution of defaults and argue that activities – more payday loans may lead
if, as the evidence suggests, elevated to more payday loans.
losses are associated with new
borrowers, this increases prevailing We also argue that existing regulation
business models’ reliance on repeat may allow ‘bad’ behaviours to be more
lending for their profitability. profitable than ‘good’ ones and that
this can lead to the crowding out of
We examine the extent to which responsible lenders.
defaults are a function of the
creditworthiness of the pool of
borrowers and the extent to which they
are the function of underwriting
standards.
PAYDAY LENDING: FIXING A BROKEN MARKET 92. The structure of the UK payday lending market
There are two markets for payday THE IMPORTANCE OF THE ONLINE Similarly, the OFT, consumer advocacy
lending in the UK, the retail market and BUSINESS MODEL groups, and lenders all report little
the online market. These markets have overlap between the online and retail
distinct characteristics and customer Online payday lending is a distinct customer bases in the UK. Online
bases. business from traditional retail payday lenders have reached different
lending. Online lending businesses demographic groups, attracted by the
THE RETAIL MARKET face: anonymity and speed of online loans
(and, no doubt, encouraged by high-
Payday lending first started in the UK in • lower operating costs profile advertising campaigns).
pawnbroking and cheque-cashing shops.
There are currently estimated to be • higher marketing costs – in The focus of this report is the online
around 1,800 stores providing payday particular the use of third party ‘lead market for a number of reasons:
loans as part of their product offering. generators’ – companies that
For some alternative financial providers specialise in sourcing the personal • The online market is significantly
payday lending provides a significant details of prospective borrowers larger than the store based market
revenue stream, while for others it is a with around two thirds of loans now
small part of their overall business. • higher loss rates due to greater originated online.8
difficulties in assessing
The retail market is dominated by two creditworthiness and preventing • The online market is growing faster
US companies: Dollar Financial and fraud. than the store-based market and is
Axcess Financial (both of which operate of increasing importance.9
under multiple brand names on the The online and retail business models
high street). Other retail lenders are significantly different; this is • Online loans carry higher charges
include: Cash Converters, Albemarle evidenced by the fact that successful, than store-based loans, so
and Bond/Herbert Brown (which experienced retail lenders have not prolonged use carries a greater risk
recently acquired a small online lender). always been able to make the online of consumer detriment.
Ramsdens and, until recently, H&T business model work. In the US the
(Farrell 2013), all of their operations are largest retail lender does not underwrite • Default rates among online
dwarfed by those of the big two. online loans, choosing instead to act as borrowers are significantly higher
an online broker for a competitor.6 In than among store-based
It is difficult to comment in detail on the the UK few retail lenders underwrite borrowers.10
business model driving retail payday online loans and those that do have
lending for two reasons: typically grown via the acquisition of
established online businesses.7
Most of the retail providers are privately
owned (rather than listed on a stock
exchange) making it difficult to obtain
detailed information about their 8. Evidence from lenders’ financial statements
combined with the OFT’s analysis of overall market
operations. size and 2010 online market shares (Office of Fair
Trading 2011a).
The ‘multiline’ nature of the business.
9. Evidence from lenders’ financial statements
Retail payday loans are always offered combined with OFT estimates of 2010 online
as part of a broader product offering, market shares. The rapid growth of online lending
there are no standalone payday lending 6. Cash America’s subsidiary, CashNetUSA.com is best illustrated by considering Cash America
shops in the UK. This means that while (formerly Enova), offers online loans marketed and Wonga.com, both of which operate exclusively
through Advance America’s website www. online and entered the UK market in 2008. In 2012
revenue streams can be categorised by advanceamerica.net they accounted for over £1.75bn of the total £3.7bn
product, even lenders themselves find it of credit extended – that Is over 47% of the
7. Dollar Financial has expanded into the UK
difficult to accurately attribute costs to combined retail and online markets.
online lending via the acquisition of various online
different products offered in the same lending businesses, including Month End Money 10. A detailed discussion of levels of default in
shop. (MEM). Cash America expanded into global online both retail and internet businesses is presented in
lending via the acquisition of CashNetUSA/Enova. Chapter 6, ‘Loss rates’.
10This report concentrates on the three
biggest online lenders operating in the
UK: Dollar Financial, Cash America, and
Wonga.com. These lenders have been
selected for three main reasons:
• They are the largest lenders:
together they account for around
70% of the online payday lending
market in 2010 (Office of Fair Trading
2011a).
• They are among the most
responsible lenders operating in the
UK. The purpose of this report is not
to highlight areas of exceptionally
poor practice by ‘rogue’ lenders,
but to further the understanding of
the online payday lending market as
a whole.
• It is possible to bring together
sufficient data to understand the
business models of each of these
lenders.
PAYDAY LENDING: FIXING A BROKEN MARKET 113. Literature review
UK RESEARCH a two year period have 12 payday loans were significantly higher than the
transactions in their second year of costs associated with repeat loans. They
This is a relatively new product in the borrowing, up from 9 transactions in concluded that, ‘The operating costs of
UK so there has been little prior the first year. In addition, evidence servicing new customers represent over
research into payday lending here. suggests that borrowers’ loan sizes 85% of the total costs across the
None of the existing UK research deals increase after their initial loan.’ industry.’(Ernst & Young 2004: 34) And,
with the payday lending business ‘Clearly, the long-run survival of a
models, or with the relative profitability The profitability of repeat lending payday loan operator will depend on
of first-time and repeat loans, focusing A number of attempts have been made achieving a steady repeat customer
instead on international regulatory to assess not just the revenues business’ (Ernst & Young 2004: 37)
alternatives and borrowers’ reported generated by repeat borrowing but the
experiences. profitability of repeat borrowing. (It should be noted that when the
Stegman and Faris (2003) used loan- CACFS commissioned a number of
INTERNATIONAL RESEARCH INTO level data from payday lending stores in follow-up reports into the cost of
RETAIL PAYDAY LENDING BUSINESS North Carolina to conclude that repeat providing payday loans in individual
MODELS business was a key determinant of Canadian provinces, data on the
financial performance. Conversely, relative costs of first-time and repeat
Revenues from repeat lending Flannery and Samolyk (2005), again loans do not appear to have been made
In the US, where payday lending is well using loan level data provided by US available again.)
established, concerns have frequently payday lenders, concluded that while
been raised about the length of time repeat borrowing contributed to loan While providing by far the best available
borrowers remain indebted to lenders volumes it is no more profitable than insight into the payday lending business
and the proportion of revenues first-time borrowing. Both these studies model, the scope of the Ernst and
generated by repeat loans (King and used multivariate regression analysis to Young report is limited to costs; it
Parrish 2011; King, Parrish and Tanik determine the impact of repeat contains no analysis of how revenues
2006). The Center for Responsible borrowing on revenues (Stegman and and therefore profits are generated. It
Lending, based in Durham, North Faris 2003) and profitability (Flannery also does not go far enough in its
Carolina, has published two reports of and Samolyk 2005). While regression analysis of patterns of default. Losses
particular relevance: analysis is a useful tool, it has many due to default are assumed to be evenly
limitations and is by no means a distributed across all loans when, in
• Financial Quicksand (King, Parrish substitute for the business model fact, loans to new borrowers carry a
and Tanik 2006) used data from approach this analysis takes. greater risk of default, further increasing
regulatory databases and found that the costs associated with first-time
90% of retail payday lenders’ In 2004, Ernst & Young was loans. It also contains no analysis of the
revenues come from borrowers who commissioned by the Canadian online lending business model, as the
take five or more loans per year Association of Community Financial vast majority of payday loans were
Service Providers (CACFS – the payday originated in store rather than online in
• Payday Loans Inc. (King and Parrish lenders’ industry association whose 2004.
2011), tracked 11,000 borrowers over members include both Dollar Financial
the two years following their first and Cash America) to conduct an
loan and found that ‘in their first objective, independent survey on the
year of payday loan use, borrowers costs of providing payday loans. The
are indebted an average of 212 days. resulting report, The Cost of Providing
Over the full two-year period, Payday Loans in Canada was prepared
borrowers are indebted a total of with the cooperation of 19 payday
372 days on average;’ and that lenders and provides the best available
‘Payday borrowers’ loans increase in analysis of the business models of
size and frequency as they continue payday lenders. Crucially, Ernst and
to borrow. Those payday borrowers Young identified that the costs
who continue to take out loans over associated with providing first-time
124. Data sources
The principal motivation behind this Also, in the case of Dollar Financial and High-level information on the market in
report is the need to improve Cash America, both of which are general is drawn from the publications
transparency. The biggest barrier to publicly traded, additional information and press releases of the CFA – the
fully informed debate about payday needed to separate information trade body representing 70% of UK
lending in the UK is a lack of hard data. pertaining to their UK operations from payday lenders, including Dollar
Payday lenders are currently under no information pertaining to their Financial and Cash America – and the
obligation to release data into the international operations and to enhance OFT, and from a report by the Personal
public domain, where independent the analysis of costs and patterns of Finance Research Centre at the
researchers would be able to carry out default is drawn from investor relations University of Bristol (2013).
their own analysis of the industry and materials and earnings calls.12
individual firms operating in the market. All information used is publicly
This report aims to bridge this In the case of Wonga.com, which is available.
information gap as far as possible: privately held, additional information is
drawn from their Written Evidence to (This work has been undertaken on a
In order to ensure the accuracy of Parliament, testimony to the Public ‘best efforts’ basis and enormous care
calculations, only lenders’ own data Accounts Committee, company has been taken to maintain a high level
regarding costs and revenues contained approved interviews in the press, and of accuracy and to provide a fair
in their published financial statements11 statistics provided via their representation of lenders’ activities. By
are used. OpenWonga website. necessity some assumptions are made.
These are explicitly highlighted in the
text and the basis on which they are
made is fully explained.)
Table 4.1 presents a summary of
statistics for the ‘big three’ lenders for
2011. (The most recent year sufficient
information can be found in lenders’
financial statements.)
12. An earnings call is a conference call in which
senior management of a listed company discuss
the company’s results with a panel of investment
analysts. It is intended to provide investors and
analysts with deeper insight into the company’s
11. For Wonga.com these consist primarily of their operations. Cash America and Dollar Financial
accounts filed at Companies House and their 2012 webcast their earnings calls via their investor
published annual report. For Dollar Financial and relations websites. For this report the relevant
Cash America these consist of their statutory earnings calls were accessed via the lenders’
filings with the Securities and Exchange websites as they became available and were
Commission (SEC), in particular, the “Form 10k” transcribed by the authors. Interested readers
– a detailed, audited annual filing essentially a very may access historical earnings calls free of charge
detailed annual report and “Form 10q” – a less at earningscast.com or transcripts may be
detailed, unaudited quarterly filing. purchased from a number of online providers
PAYDAY LENDING: FIXING A BROKEN MARKET 13Table 4.1: Statistics for 2011
Dollar Wonga Cash America
Financial
(Online only)
Total credit extended £495ma £707me £507mh
Total revenue £122ma £184me £114mh
Revenues as a % of credit extended 25% 26% 22%
Losses as a % of revenues 35% b
36% e
45%i
Average loan size £270 c £287f £336 h
Average revenue per loan £66 £75 £75
Average number of loans per borrower 3.68 d
3.00 g
3.68 d
Average revenue per borrower £243 £225 £276
Key and sources
a Includes estimated full-year activities of Month End Money (MEM). Source: Dollar Financial 10ks and 10qs.(DFC Global Corp 2011a, b, c and 2012b) MEM
accounts filed at Companies House (MEM 2011)
b Includes estimated full-year activities of Month End Money (MEM). Source: DFC Global Corp 2012a
c Source: OFT2013b
d Source: Consumer Finance Association 2012a
e Source: Wonga.com accounts filed at Companies House (Wonga.com Limited 2012)
f Source: Wonga.com accounts filed at Companies House (Wonga.com Limited 2012)
g Source:.UK Government 2011
h Source: Cash America 2012a
i Source: Cash America 2012a
145. Customer Acquisition Cost
Lenders’ principal justification for their However, if operating costs are the WHAT IS CUSTOMER ACQUISITION
high charges is that the set-up, or principal determinant of payday interest COST?
operating, costs of a loan (things like rates, firms facing the lowest costs
credit checks, verification of borrowers’ should charge the lowest interest rates. Customer Acquisition Cost (CAC) is the
details, setting up payments, etc) are Why, then, do online lenders, who face cost to a business of acquiring each
broadly the same regardless of the substantially lower operating costs than new customer. CAC is computed as
loan’s size and length. This, retail lenders, charge the highest APRs? total acquisition cost, ie the sum of all
unavoidably, makes small-sum, short- expenses related to introducing new
term loans such as payday loans very Far from competing with retail payday customers to the company’s goods and
expensive in APR terms. lending and driving prices down in both services, divided by the number of new
markets, online payday lending charges customers. For online payday lenders
The CFA currently has this Industry started high and have remained high. total acquisition cost includes money
Briefing regarding APRs on its website: Why is this? What costs do lenders spent (or revenue foregone) on the
‘the costs of lending this way are high. actually face? A Dollar Financial following:
The cost of lending someone a small executive commented: ‘as we’ve said
amount, eg £200, is the same as lending before internet loans typically carry • lead purchase
a larger amount, eg £5,000. It entails higher loan losses but with significantly
the same credit checks, bank lower fixed operating costs than the • TV, radio and print advertising to
verification checks, fraud prevention company’s existing store based new customers
checks and regulatory requirements businesses in those countries.’ (DFC
including anti-money laundering, Global Corp 2012a) One of Cash • internet advertising (‘pay per click’,
mental capacity and responsible America’s executives identifies the two ‘pay per call’ and search engine
lending checks. Underwriting 25 × £200 key drivers of costs in his lending optimisation) to new customers
loans (£5,000 total) clearly increases the business as: ‘it’s a function of, obviously,
cost to the lender 25 fold’ (Consumer loss rates, it’s a function of customer • sales and marketing headcount
Finance Association 2013b). acquisition cost.’ (Cash America 2012b) costs attributable to new customer
acquisition
Similarly, Wonga.com’s founder and Loss rates and Customer Acquisition
former CEO Errol Damelin commented Cost explain why online payday lenders • ‘Refer a friend’ programmes
‘We do small, short-term things, and the charge higher prices than retail payday
cost of delivering that service is high’ lenders. They also have important • discounting of first loans
(Shaw 2011). The CFA further argues implications for the length of time
‘Set the rate (cap) too low and payday borrowers remain indebted and the • additional work involved in
lenders will no longer be able to afford number of borrowers experiencing processing the borrower’s initial
the high operational costs…thereby repayment difficulties. application
putting them out of business’
(Consumer Finance Association 2013b). Loss rates, and the patterns of default • processing initial applications which
Determining how much ‘headroom’ they imply, are examined in detail below are subsequently declined.
there is in existing business models is in First Customer Acquisition Cost, the
therefore now extremely important. total cost of acquiring a new borrower,
is explored.
PAYDAY LENDING: FIXING A BROKEN MARKET 15How significant is CAC? THE RELATIONSHIP BETWEEN CAC marketing spend and the return it
Advertising and marketing often seem AND REPEAT LENDING generates. In the words of Dollar
like optional extras that help a business Financial ‘We actively measure and
grow but are not central to its survival. No business spends more money on conduct testing of our advertising
However, online businesses often need customer acquisition than it expects to programs to ensure we achieve a
to spend significant amounts on get back through increased sales. For positive return on investment’ (DFC
advertising as they lack a physical payday lenders increased sales means Global Corp 2012e: 16). Therefore,
presence with which to draw attention more loans – specifically, more loans to analysis of CAC yields very robust
to their products. For online payday the same borrowers. information regarding lenders’
lenders CAC is significant and a key expectations of CLV and hence levels of
driver of overall profitability. How many more loans? Each new loan repeat borrowing.
generates revenue in the form of
Peer-to-peer payday lender Lending interest charges and fees, but not all of
Well claims that CAC is one of the main this revenue is available to offset the
reasons the APR of 4,200% it charges CAC. This is because there are other
borrowers is so far above the rate of costs associated with making loans,
return of 12% it pays investors. ‘One of regardless of whether the borrower is a
the main reasons that payday lending new customer or not, things like
can seem expensive is that the cost of financing cost, some operating costs
customer acquisition, credit checking and administrative costs, etc. Only the
and so forth is fixed and high’ (Insley pre-tax profit – interest and fees minus
2012). other costs but before taxes – is
available to offset CAC. Lenders only
Removing or restricting CAC can break even when the sum of all pre-tax
significantly reduce APRs, as in the case profits13 the borrower generates – called
of US lender BillFloat (now called ‘Better the ‘Customer Lifetime Value’ (CLV)
Finance’), which offers short-term loans – exceeds the CAC. (To break even is
to utility companies’ customers via their obviously a baseline scenario, in fact, a
websites: ‘BillFloat CEO Ryan Gilbert good online business aims to generate
says his company’s loans, which max out CLV many times greater than CAC.)
at $200 (£120), don’t exceed a 36
percent APR. The much lower cost Whatever form it takes, CAC is always
doesn’t come so much from better risk an up-front cost paid out by lenders
assessment, though that plays a part, before even the first loan is repaid.
Gilbert says. Instead, he says, BillFloat Lenders really put their money where
can keep its own costs low because it their mouths (or, rather, their statistical
doesn’t have to spend money on models) are when it comes to the
getting new customers. Rather than amount they are willing to pay to
having to advertise, BillFloat just shows acquire new borrowers. They are
up as another option alongside Visa acutely aware of advertising and
and Mastercard when you sign in to pay
your bill’ (Wohlsen 2013).
13. Technically, the pre-tax profit should be
discounted from the date it is accrued to the date
the CAC was incurred at the lender’s cost of
capital. As we do not know when the borrower will
take each loan and as the effect of discounting will
always be to increase the number of loans required
to break even (the lender’s cost of capital is always
greater than zero) this step has been omitted in
the interests of simplicity. The analysis presented
here could be extended to add this extra level of
complexity if required.
16BOX 5.1: EXAMPLE, CAC–CLV
The relationship between CAC and CLV can be visualised Figure 5.1: CAC and CLV at the inception of the
as a seesaw: on the left-hand side the CAC, the money first loan
spent to get the borrower through the door, weighs the
seesaw down (Figure 5.1).
At the end of the first loan the borrower repays the
principal plus interest and fees generating a small pre-tax
profit for the lender; this money goes on the right-hand
side of the seesaw (Figure 5.2).
CAC
Each time a loan is repaid some more pre-tax profit is
generated and some more money can be added to the
right-hand side of the seesaw. It is only when the two sides
of the seesaw are perfectly balanced that the lender breaks
even and can start to make a profit (Figure 5.3).
For example, if CAC is £100 and pre-tax profit per loan is Figure 5.2: Customer Acquisition Cost and Customer
£50 the lender breaks even when the borrower takes two Lifetime Value at the end of the first loan
loans (2 × £50 = £100). If pre-tax profit is only £25, however,
the lender requires the borrower to take four loans
(4 × £25 = £100) in order to break even.
In the simple examples illustrated, each loan is equally
1
profitable. This need not be the case; perhaps the borrower Loa n
takes a mixture of small and medium-sized loans,
generating a mixture of small and medium profits, or one CAC
large loan generating a single large profit. Whatever the
exact pattern of loans, one thing is certain: only when the
sum of the pre-tax profits adds up to CAC will the lender
begin to make a profit.
Figure 5.3: Customer Acquisition Cost and Customer
Lifetime Value at the end of the third loan
Loan 3
CAC Loan 2
Loan 1
PAYDAY LENDING: FIXING A BROKEN MARKET 17CASE STUDY: CUSTOMER ACQUISITION COST
By far the best insight into CAC comes from the prospectus Cash America do not customarily split out details of their
Cash America produced in September 2011 ahead of its costs by geographic region but in the Enova prospectus
(subsequently cancelled) attempt to spin off its internet they did so. Figure 5.4 shows the percentages of revenue
lending operations, which it calls Enova International, Inc. spent on different categories of costs
Cash America’s Enova business operates in the US, the UK, This information presents a unique opportunity to gain
Australia, and in three provinces of Canada. It offers payday insight into the costs associated with providing online
loans in all locations and, since 2010, instalment loans in payday loans in the UK.
the US and the UK only (Table 5.1). Revenues from foreign
operations are a significant and growing percentage of The cleanest data, from 2010, forms the basis of the
total revenues Customer Acquisition Cost case study presented here.
(Analysis of the 2011 data generates similar results but
Table 5.1: Cash America revenues (online lending only) requires some additional assumptions.) In order to analyse
the data a few simplifying assumptions are required:
Country 2010 2011 2012
US 73.0% 53.0% 50.5% • The percentages of revenue spent on the various
UK 25.0% 44.0% 46.5%* categories of costs remained the same for full year
2010.14 (The figures in the Enova prospectus were for
Canada and Australia 2.0% 3.0% 3.0%*
the first half of the year only.)
*For 2012, 49.5% of total revenues came from outside the US, primarily the
UK. We have assumed Canada and Australia continued to contribute 3% of • Instalment lending constituted less than 1% of total
total internet revenues.
lending for the year, hence all loans are treated as if
Source: Enova Prospectus (2011) and Cash America (2013) they were payday loans.
Figure 5.4: Cash America profit and costs – UK, Canada • As instalment customers were overwhelmingly recruited
and Australia online lending only from the pool of existing payday borrowers, all
instalment loans are treated as repeat loans.
100%
Profit, 5.45% Profit, 9.24% • As 93% of revenues came from the UK the entire foreign
business is assumed to be representative of the UK.
80% Losses
44.78% Losses
48.35%
60%
Advertising and marketing
40% 19.20% Advertising and marketing
17.27%
Administrative costs Administrative costs
20% 16.15% 12.16%
Operations and tech Operations and tech
14.10% 12.53%
0
Finance costs, 0.32% Finance costs, 0.45% 14. The figures in the Enova prospectus were for the first half of the year
only. The purpose of a prospectus is, however, to accurately represent the
6m ended June 2010 6m ended June 2011 nature of the business to potential investors. Coupled with the fact that
there is no evidence of ‘seasonality’ in UK payday lending, this means it is
safe to assume that the structure of costs in the first half of the year did not
Source: Enova Prospectus (2011). diverge significantly from that in the second half of the year, as this would
have been noted in the prospectus.
18Case study: continued
DATA AND METHODOLOGY USED Second, Cash America and the other big lenders used
Google Adwords to acquire an undisclosed number of
• Cash America generated foreign online lending borrowers. Borrowers acquired in this way were even more
revenues of £65,846,799 and gross profit of £3,585,668. expensive (with individual acquisition costs potentially
running into the hundreds of pounds) to acquire than those
• Number of first loans made = 151,000.15 acquired via lead purchase.
• Number of repeat loans made = 772,474.16 (Both lead purchase and the use of Google Adwords are
discussed in detail below under ‘Shared acquisition
• We divide the costs into three broad categories: strategies’.)
–– Advertising and Marketing £12,645,149. Lenders are known to be very keen to retain borrowers;
however, customer retention is significantly cheaper than
–– Administration, Operations and Technology, and customer acquisition, particularly as lenders are very
Financing £20,130,354. ‘tech-savvy’ and target existing customers via text
messaging and email at minimal cost. Further, as will
–– Losses £29,485,628. become clear, because borrowers frequently cannot repay
on time and so roll over or refinance, they are effectively
We now build a model of a payday lending business with retained without additional cost to the lender.
the same characteristics. Ignoring losses for the time being
(they are explored in much greater detail in Chapter 6) a Table 5.2 gives a breakdown of advertising and marketing
simplified model of costs can be built in the following way: spend.
ADVERTISING AND MARKETING Table 5.2: Advertising and marketing spend
Assume that 80% of the model business’s advertising and Total advertising and marketing spend on customer £10,116,119
acquisition
marketing spend was aimed at acquiring new customers.
Total advertising and marketing spend on customer £2,529,030
How reasonable is this assumption? The figure of 80% may retention
seem extreme and, perhaps, arbitrary but it is consistent Number of customers acquired 151,000
with everything that is known about online payday lending Number of repeat loans made 772,474
customer acquisition in the UK.
Advertising and marketing spend per customer acquired/ £66.99
first loan
First, Cash America sources over half of its borrowers Advertising and marketing spend per repeat loan £3.27
(globally) via lead generators –third-party companies that
specialise in sourcing prospective borrowers (Enova
ADMINISTRATION, OPERATIONS AND TECHNOLOGY
Prospectus 2011). According to the OFT, successful sales
AND FINANCING COSTS
lead cost £80 in 2010 (Office of Fair Trading 2010b: 87).
First loans are more expensive to make than repeat loans.
Additional work is required to process the borrower’s initial
application and a large number of initial applications are
15. Cash America online added the following numbers of new customers in processed but subsequently declined.
2010: 138,000 UK; 9,000 Australia; 4,000 Canada.
16. Includes 5,018 instalment loans. We understand the borrowers who This additional work and expense can be represented in
took out instalment loans were overwhelmingly existing customers, so
the model by assuming first loans cost twice as much to
these loans are included in the category ‘repeat loans’. They represented a
tiny fraction of the business in 2010, so their treatment has little impact on make as repeat loans do. This is similar to the approach
our model. taken by Ernst & Young in their report The Cost of
PAYDAY LENDING: FIXING A BROKEN MARKET 19Case study: continued
Providing Payday Loans in Canada (2004); however, they Cash America normally charges between 20% and 29.5%. A
applied this simplified methodology to all costs, whereas in weighted average interest rate of 22.65% ensures the
Table 5.3 it is used only for this sub-set of costs. model business’s total revenue matches Cash America’s
reported revenue.
Table 5.3: Administration, operations and technology
and financing costs Cash America routinely offers a 25% discount on first time
payday loans to new customers. We apply this discount to
Total administration, operations and technology and £20,130,354 all first-time loans extended by the model business
financing costs
(Table 5.6).
Total Number of Loans made 923,474
Number of first loans made 151,000 Table 5.6: Revenues including discounting of first-time
loans
Number of repeat loans made 772,474
Revenue per first loan £47.01
Administration, operations and technology and financing £37.47
costs per first loan Discounted revenue per first loan £35.26
Administration, operations and technology and financing £18.74
cost per repeat loan Revenue per repeat loan £78.35
TOTAL COSTS
It is immediately striking that in our model the revenue per
first loan, £35.26, is significantly lower than the cost per first
Adding the two categories of costs together gives total
loan, £104.46. The first loan is a ‘loss leader’ and it follows
cost per loan (Table 5.4)
that the model business is dependent on repeat lending
for its profitability.
Table 5.4: Total cost per loan
Total cost per first loan £104.46 BREAK-EVEN POINT
Total cost per repeat loan £22.01
In fact, it is not until the borrower repays the third loan that
the model business reaches the break-even point
REVENUES (Table 5.7).
The other side of the equation is, of course, revenues. Table 5.7: Breaking even
Assume that the size of first-time loans is 60% of the size of
repeat loans. How reasonable is this assumption? Lenders Cost Revenue Profit/loss Cumulative
Profit/loss
routinely restrict the size of first loans to new customers to
mitigate losses due to defaults. Table 5.5 presents average Loan 1 −£104.46 £35.26 −£69.21 −£69.21
loan sizes. Loan 2 −£22.01 £78.35 £56.34 −£12.87
Table 5.5: Average sizes of first time and repeat loans Loan 3 −£22.01 £78.35 £56.34 £43.48
Average loan size £321.41
Note that this is a stylised model. It seems unlikely that new
Average first loan size = 60% of repeat loan size £207.55
borrowers step straight up from a small first loan to a large
Average repeat loan size £345.92 second loan and perhaps not all borrowers receive the 25%
discount.
20Whatever the exact pattern of loans HOW TYPICAL IS CASH AMERICA’S highest commission and the ‘last look
taken by each individual borrower it is CUSTOMER ACQUISITION COST? lead’ pays the lowest commission in the
clear from the case study that high CAC ping tree. The lead generator works
means lenders cannot breakeven before While each lender employs its own with a network of ‘affiliates’ (eg online
borrowers have taken multiple loans. It unique set of customer acquisition loan brokers, email and SMS marketers)
therefore follows that profitability is strategies some strategies are common that run marketing campaigns to
dependent on repeat lending. to all three large lenders, in particular: increase the volume of leads.
Of course, not all borrowers take three • Lead purchase. The lead (ie prospective borrower)
loans. Some take a single loan, repay it submits one loan application via an
and walk away. These borrowers are • Additional work involved in affiliate’s website. Their details are
using payday in the way lenders claim it processing the borrower’s initial passed across the ‘tree’ of lenders until
is designed to be used, to overcome an application. one of the lenders accepts (or else
exceptional and very short term cash presumably the application is rejected).
shortfall. Unfortunately, due to high • Processing initial applications which The most common ways in which
CAC each borrower who walks away are subsequently declined. lenders pay for these services seem to
after a single loan leaves the lender out be pay per lead (eg for each application
of pocket; in order for lenders to make a • Use of Google Adwords. that is submitted) or pay per sale (ie
profit (which they do) another borrower when a loan is made).” (Bristol 2013: 41)
must be take more than three loans to First, these shared acquisition
make up the difference. In fact, the strategies are discussed in detail and Due to high rejection (on the part of the
more people who use payday as then specific details of spending and lender) and high refusal (on the part of
advertised, the worse things must be strategies employed by Wonga.com the borrower) rates ‘pay per sale’ prices
for the unfortunate sub-set of repeat and Dollar Financial are discussed. are much higher than ‘pay per lead’
borrowers. prices. The OFT believes that ‘a
SHARED ACQUISITION STRATEGIES successful lead will generate a payment
Just as the CAC of £94 (computed as of around £80 (regardless of the sum
the total cost of a first loan, £104.46, Lead purchase borrowed by the borrower) from the
plus the discount on first loans, £11.75, Lenders routinely purchase the details payday lender to the lead generator’
minus the total cost of a repeat loan, of prospective borrowers, called ‘leads’, (Office of Fair Trading 2010b: 87).
£22.01) is an average, so is the number from third-party companies that
of loans needed to recoup it an specialise in sourcing prospective This is absolutely consistent with the
average. Behind the average of three borrowers, called ‘lead generators’, or CAC modelled in the Customer
loans lies a distribution. ‘lead providers’. Lead generators run Acquisition Cost case study. Crucially,
websites where prospective borrowers the ‘sales lead’ cost of £80 is paid
Furthermore, because three loans are fill in their details (borrowers are often regardless of the amount of the loan.
required just to reach the break-even unaware that they are not dealing The price of £80 is a lot of money to pay
point, this represents a baseline directly with the lender). The lead to acquire someone looking to borrow a
scenario. A good online business model generator then acts as a credit broker, small amount for a very short time. If
has an expected CLV many times passing each borrower’s details to a anything, lead prices are now even higher.
greater than CAC. In order to make lender or lenders. One of Dollar Financial’s executives
profits, our model business requires stated that ‘The (UK) internet lending
borrowers to take more than three loans According to the report by the Personal market has become highly competitive
each on average. Finance Research Centre, University of with many providers bidding up new
Bristol (2013), in order to generate the customer leads to cover shortfalls in
highest revenues,“lead generators may revenue stemming from limitations on
develop a ‘ping tree’, which is a panel of rollovers’ (DFC Global Corp 2013d).
online lenders that are ranked in order Where borrowers are acquired via lead
of how much commission they pay for purchase, profitability is absolutely
each lead. The ‘first look lead’ pays the dependent on repeat borrowing.
PAYDAY LENDING: FIXING A BROKEN MARKET 21In the US consumer advocates have According to the OFT, in 2010 Cash verify some applicants’ bank account
already noted that high lead purchase America purchased 20% of all payday details manually. It seems reasonable to
costs make lenders reliant on repeat leads sold in the UK, as did Dollar assume that such verification is more
lending to break even. According to Financial (including Month End frequently required for first-time
Jean Ann Fox, Director of Consumer Money17), while Wonga.com purchased applicants than for returning borrowers.
Protection at the Consumer Federation 10%.
of America: ‘the use of lead generators In December 2011 Cash America
makes it an even higher priority for Lenders are competing with each other launched a ‘Pay per call’ programme
payday lenders to push borrowers into for leads; it is therefore reasonable to (Nemechek 2011) (in addition to its ‘Pay
multiple loans. “The price structure for assume that they face similar costs per per click’ marketing efforts), as they
marketing payday loans online makes lead. High CAC is endemic in online receive a significant number of
loan flipping economically essential for payday lending in the UK (and enquiries by telephone. Again, it is
lenders to make a profit,” she says. internationally). reasonable to assume that a
“Payday lenders pay up to $125 per disproportionate number of first-time
qualified lead, which requires several Additional processing time applicants require telephone
loan renewals just to recoup the cost of While lenders have been able to assistance.
acquiring the borrower”’ (Sandman 2012). automate much of the application
process, credit- checking, income and Applications that are subsequently
Cash America sources over half of its identity verification, etc, they still spend declined
borrowers (globally) via lead generators, more time on the average first-time Wonga.com rejects over 60% of
relying on just seven companies to application by a new borrower than they applicants (UK Government 2011);18 the
provide 81% of leads (Enova Prospectus do on repeat applications by existing CFA say their members routinely reject
2011). They are not alone, all three of borrowers. Even Wonga.com, which over 90% of applicants. According to
the big lenders purchased significant prides itself on its automated lending one Dollar Financial executive talking
numbers of leads in 2010 (Figure 5.5). process, employs a ‘verification team’ to about the UK online payday lending
business, ‘we only…approve, I should
say, about 15% of the applications we
Figure 5.5: Share of leads purchased get and then the customer only accepts
that funding and puts a loan on the
books for us for maybe 25% of that’
(DFC Global Corp 2013a). This implies
Other Cash America that just 3.75% of applications are
(20%) (20%) actually converted into loans.
There are costs associated with the
Wonga approval process. Running a credit
(20%) check, for example, appears to cost
Dollar Financial
(20%) around £2 (UK Government 2013: 39).
The costs associated with the approval
Wage Day Advance
of applicants who do not take a loan
(15%)
Pounds Till Payday must be borne by those who do: this is
(15%) part of their CAC.
Source: OFT Decision to approve Dollar Financial’s acquisition of Month End Money
(Office of Fair Trading 2011a).
17. Month End Money was acquired by Dollar 18. OpenWonga.com statistics downloaded July
Financial in April 2011. 2012 and January 2013.
22Google Adwords Refer a friend scheme practices, were they to be performed by
The use of Google Adwords is probably Wonga.com encourages existing a paid agent) when this kind of ‘refer a
the most expensive customer borrowers to introduce new borrowers friend’ scheme is allowed.
acquisition strategy lenders employ. to them via the ‘Refer a Friend scheme’.
Google allows advertisers to pay to Discounting Wonga.com routinely
have their link appear at the top of the How does the ‘Refer a Friend’ distributes discount codes, offering to
results page generated whenever scheme’ work? waive the £5.50 transmission fee on
someone searches for their chosen ‘We give each of our first-time loans to new customers.
‘adword’. Advertisers pay for the
prominent positioning of their link on a
customers a unique “refer a Total advertising and marketing spend
‘pay-per-click’ (PPC) basis. The adword friend” code. You can find is likely to be significantly higher than
‘payday’ sells for over £20 per click, ie in yours by logging into the My the advertising budget estimated by AC
order to appear in one of the top three Account section in our Nielsen MMS, as this figure does not
spots on the ‘payday’ results page, include internal marketing and
lenders must pay over £20 for every website. If you know someone advertising headcount or lead purchase
click on their link (Sommerlad 2014). who wants to take a loan with costs and is therefore not directly
us, you can give them your comparable with Cash America’s total
Not all clicks convert into loan advertising and marketing spend
code to enter in the
applications and lenders routinely detailed above.
reject 90% of applications, so the costs “promocode” box under the
of PPC advertising quickly mount up. sliders, when they apply. If this Dollar Financial
Even if a loan was generated for every is their first Wonga.com Dollar Financial reports advertising and
10 clicks on a lender’s link, this would marketing expense at the global level,
imply an external CAC of £200 for loans
application, we will remove ie consolidated across all business lines
generated in this way. our £5.50 transfer fee from in all countries. However, there was a
their loan balance. If your significant increase in global advertising
Wonga.com friend’s loan is for £50 or more and marketing expense (Figure 5.6)
It is no secret that Wonga.com run very after their acquisition of the Month End
high profile (and expensive) advertising and meets our refer a friend Money UK online payday lending
campaigns. Their advertising spend was criteria…we will send £20 cash business in April 2011.
estimated by the agency AC Nielsen straight to your registered
MMS to be £16m in 2011 (Gentleman March 2010 – March 2011 Total global
bank account as a thank you
2012) and included, ‘sponsorship of all Advertising Spend £14.4m.
three CSI series and The Mentalist on for introducing a new
Channel 5, using the Rawhide theme customer to us’. March 2011 – March 2012 Total global
tune for its commercial radio ads, and Advertising Spend £31.3m.
plastering buses throughout London. (WONGA.COM WEBSITE N.D., 3)
The company sponsors Blackpool and Global advertising spend for the 12
Heart of Midlothian football teams and This equates to an external CAC of months after MEM was acquired was
advertises on football clubs’ websites’ £25.50 not including the internal £16.9m higher than for the previous 12
(Neate 2012). In 2012, Wonga.com headcount cost of administering the months. This significant change in
signed a deal with Newcastle United scheme. spending generated some interest from
reported to be worth £24m over four investment analysts covering Dollar
years (Conn 2012). As well as television Payment can even be offset against a Financial’s stock.
and online advertising and sports referrer’s existing arrears. It is easy to
sponsorship, Wonga.com acquires imagine a borrower in an extremely
customers through a variety of difficult situation exploiting their
channels, including ‘refer a friend’ knowledge of another person’s situation
programmes, discounting of first loans, (ie straying into what would be
affiliate marketing and lead purchase. considered ‘aggressive’ commercial
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