Ending 'rate exportation' in consumer finance

Current law, as interpreted in a 1978 U.S. Supreme Court case called Marquette, dictates that lenders’ home states should “export” their rate caps to consumers all over the country. Interest rate caps are not unambiguously good public policy. Rate caps reflect a paternalist, quasi-religious sensibility that some credit is simply too expensive, as a normative matter.  But the sad fact is that many lower- and middle-income American households are simply not creditworthy at anything other than lofty interest rates.

As the Senate races toward a vote on its sweeping financial reform bill, it might consider an amendment, introduced by Sen. Whitehouse, that would markedly change the nature of interest rate caps in consumer finance. Consumer activists are feverish in their support, arguing in part that more stringent state-imposed rate caps would curtail predatory and unscrupulous practices by national banks.

The activists are right to support the Whitehouse amendment, but they do so for the wrong reasons. The amendment is a good idea, not because rate caps are particularly wise, but because the decision on whether to implement them is most appropriately taken by consumers’ home states, and not by lenders’ home states. Current law, as interpreted in a 1978 U.S. Supreme Court case called Marquette, dictates the opposite -- that lenders’ home states (most famously and improbably, South Dakota) should “export” their rate caps to consumers all over the country.

Interest rate caps are not unambiguously good public policy. At the core, rate caps reflect a paternalist, quasi-religious sensibility that some credit is simply too expensive, as a normative matter.  But the sad fact is that many lower- and middle-income American households are simply not creditworthy at anything other than lofty interest rates.  As real incomes have stagnated, and costs of living have continued to climb, American families’ financial lives have become increasingly precarious.  Artificially low rate caps would necessarily truncate credit extension to precisely those precarious households.  In a world where access to credit is more a necessity than a luxury, that would be unfortunate. 

The danger, of course, is that high-risk subprime lending often appeals to the most unscrupulous lenders, and to the consumers most susceptible to deception.  Absent a regime that requires and enforces transparent product pricing and structures, high-cost lending becomes a petri dish for all species of abuse.  Before the existence of a federal consumer financial protection agency, and indeed even afterwards, the principal responsibility for such an enforcement regime falls to the states.  And, although it is to my mind the wrong substantive answer, many states might plausibly find that the effort of rooting out pervasive abuse is simply too great compared to the upside of widely available credit.

But this analytical tradeoff -- the costs of enforcement versus the benefits of high rate caps -- illustrates why today’s Marquette rate exportation regime is so problematic.  The costs of enforcement are principally borne by federal authorities and by consumers’ home states, but the decision on whether and how high to set rate caps is taken by lenders’ home states.  This creates a clear decision bias towards high rate caps for a state like South Dakota, which is (not coincidentally) a magnet for national consumer lenders, but which bears virtually none of the potential costs of high rate caps itself, owing to its tiny population.

Of course, Marquette-style rate exportation does have one benefit:  It creates a de facto national standard for what are, in consumer finance, increasingly national businesses.  But if that desire for efficiency and uniformity were the overriding concern, then this would be a decision best left to the U.S. Congress, not to the South Dakota legislature.  In other words, given the three choices of who should decide interest rate caps (Congress, lenders’ states, or consumers’ states), Marquette has left us with exactly the worst answer. 

We should be deeply skeptical about the wisdom of pervasive and binding interest rate caps, but there is no question at all that lenders’ home states should not be the ones deciding the question.  The Whitehouse amendment should pass. 

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.   Cambridge Winter is a non-profit, non-partisan think tank focused exclusively on financial institutions policy.