Blog: Learnings for the UK from international experience of credit market reform and the rise of illegal lending

This blog is taken from written material supplied to us by Anna Ellison and Martin Coates from Policis. For presentation purposes to limit the size, Fair4All Finance has edited and abridged the original supplied text.

Analysis by Policis was based on 10.4million actual loan transactions representing a significant share of the USA online small sum loan transactions in 2010 – 2014[i]. The section on Japan is based on analysis of Japan over a ten year period 2004 – 2014 immediately preceding and post market reform[ii].

Whilst the editing, layout and format was undertaken by Fair4All Finance and is published in our branding; the data, the analysis and conclusions drawn are unchanged from the material supplied to us by Policis. Any factual error or in interpretation of the data is therefore the responsibility of the report authors, Anna Ellison and Martin Coates.

Introduction

In April 2024, Fair4All Finance published a report entitled Access to Credit and Illegal Lending which describes the consumer and credit market and the effects of the various reforms introduced by the FCA over recent years. The report outlines that certain households face significant challenges to access credit, both in the enquiry stage and at application or direct to lender considerations.

The data in the report and the findings are reflective of similar experiences from other international markets following significant credit market reform and suggest a pattern – and even a degree of universality in terms of market and consumer impacts – that we aim to explore in this blog.  

In each case reform followed the establishment of powerful new regulators with a mandate to clean up markets perceived as disorderly and detrimental to consumers. This blog will consider the effects of the credit market reforms which followed the establishment of the Japanese Financial Services Agency (FSA) in 2000 and the Financial Consumer Protection Bureau (FCPB) in the US in 2011.

It will show that despite significant differences in timing, geography, political and cultural contexts there are striking similarities in the outcomes of reform in each country, the way that reform impacted domestic credit markets and different groups of consumers and the timescales over which these developments occurred. 

Importantly, in considering the implications for the UK, the UK now stands at the same distance in time from critical market reforms and is at the same point in the cycle of reform and market response as was the US and Japan in the period covered by our analysis.

It is important to say that in both the US and Japan, reform generated significant consumer benefits. This blog however focuses on some of the unintended effects of reform and in particular the development of illegal lending in these markets. There may be important lessons to be drawn from international experience in crafting UK credit market policy for the future. 

In both the US and Japan it took approximately seven years from the original point of regulatory intervention to a tipping point where illegal lending, particularly digital illegal lending, began to scale rapidly.

In this blog we describe the key findings from our previous research in both the US[iii]  and Japan in the period preceding and directly after major reforms of the credit markets in each country[iv] . 

Summary of the Fair4All Finance Analysis

Due to significant differences in the credit landscape in Northern Ireland, the Fair4All Finance research is focussed on Great Britain, rather than the whole of the UK. Our understanding of their analysis is that the key findings are that:

• Many credit users, and particularly those who are better off, have benefitted from reform in a number of ways 
• For others, notably those on low incomes, the credit market is no longer functioning effectively in that access to credit has become increasingly difficult 
• This in turn has resulted in a shift to both informal borrowing and, more concerning, to use of illegal lenders, both within the community and online  

Analysis of the US experience

In the US, from around 2005 digital illegal lending grew, gradually at first, in part driven by a new breed of licensed, listed online-only small sum lenders[v]  Digital illegal lenders also entered the market to fulfil unmet demand arising from the state level reforms of the early 2000s, rapidly taking share from licensed lenders. By 2012 Policis analysis of total loan transactions[vi]  indicated that unlicensed lenders were making 3 out of 5 small sum loans online in the US. Digital illegal lenders[vii]  dominated the market with a 59% share of the US small sum online loans market[viii] .  

By 2012 digital illegal lenders were making some 21 million small sum loans annually worth some $9.7 bn, with these lenders used by 2.4 million US consumers. Illegal lenders websites typically mimicked the look and feel of authorised lenders. Consequently, consumers were unable to distinguish between authorised and illegal lenders online.

Digital illegal lenders claimed their ‘authority’ from alternative -offshore – jurisdictions or, in the case of ‘tribal’ lenders, immunity from state licensing laws on the grounds of ‘sovereign nation’ status, a stance not accepted by either state or federal regulators.

The evidence suggests that there was a spectrum of greater or lesser harm resting on digital illegal lending. At one end digital illegal lenders were at least in the lending business, albeit that they might not observe local, state or federal regulations, conduct standards or price or other controls. At the other, bad actors present as lenders or brokers but were in fact in the data collection business, collecting personal financial data as a criminal asset to support cyber- crime. 

Consumers who would not dream of using an unlicensed lender were unaware that in supplying detailed financial and personal data in support of a credit application, they were potentially interacting not only with unauthorised lenders but potentially even criminal enterprise.

Digital illegal lenders were able to grow their business by aggressively exploiting their competitive advantage over licensed lenders. Illegal lenders rapid growth and ultimate market dominance did not rest only on unmet demand but was driven rather by taking market share from legitimate lenders, specifically targeting the most profitable customers (who were unable to distinguish them from licensed lenders).  

In this respect illegal lenders enjoyed a decisive competitive advantage over licensed lenders, which were constrained by conduct standards, caps on pricing and by the significant costs of compliance. 

Illegal lenders were able to make assertions on costs that did not reflect reality and made claims that could not be made by compliant lenders (such as no credit checks, guaranteed acceptances, multiple loans permissible). Untroubled by compliance costs, illegal lenders could aggressively cut pricing to levels which compliant lenders were unable to match, thus attracting the more price-sensitive frequent and repeat borrowers and those seeking larger loans. For the same reason, unauthorised lenders could also outbid licensed lenders when buying leads. 

Illegal lenders could offer the most profitable customers apparently keener pricing, more attractive products, faster delivery and a more convenient customer journey (albeit that upfront pricing hid the reality of exploitative pricing structures, aggressive penalty charges, egregious collection behaviour or unfair or misleading terms).

For those actually excluded from the market, digital illegal lenders had no need to compete with licensed lenders unable to serve such customers post reform. Illegal lenders rather provided credit to these customers at very high cost, typically with minimal transparency on price or terms. Users of digital illegal lenders in the US were the mass market not the very poor.

In a modern digital lending market, therefore users of digital illegal lenders are not solely the credit excluded but include also the licensed lenders’ formerly most profitable customers, heavy credit users and repeat borrowers, who may be both upmarket and have multiple credit options.  

Users of digital illegal lenders span all incomes, age and socio-economic groups but are biased to younger and family households. The key determining factor in use of digital illegal lenders is to what extent individuals are tech-savvy and live their lives online.

Based on Policis analysis of millions of actual loan transactions, the data shows that consumers using illegal lenders experienced far worse outcomes across all potential dimensions of welfare than those using regulated lenders, while also creating profoundly disorderly markets. This wasin terms of credit cost, stretched affordability, problem debt, egregious lender conduct, exploitative business models and financial breakdown 

For example, users of online illegal lenders paid an average $37 per 100 dollars borrowed compared to an average of $23 for licensed lenders. Similarly problematic debt (impaired and written off loans) was almost twice as high among users of digital illegal lenders (34%) than among users of licensed lenders (18%).

Poor credit market outcomes were not the only detriment experienced. One of the more detrimental outcomes of the emergence of digital illegal lending was that online credit applications became a gateway for financial and data crime impacting a significant subset of users of online lending. The sheer scale and ubiquity of demand for credit presents cyber-criminals with a unique opportunity to reach mass market consumers and to exploit the personal and financial data contained in credit applications. 

As digital illegal lending and the presence of bad actors and criminal enterprise within the market grew, users of digital illegal lenders became increasingly exposed to financial and data crime. The most common examples of the harm arising from financial and data crime were:

• The sale of personal financial data as a criminal asset
• Identity theft and fraud,
• Theft and unauthorised withdrawals from customers’ and applicants’ bank accounts.

As personal financial data became a valuable criminal asset, it might be sold on multiple times, amplifying the harm to consumers, and extending the period over which they are exposed to detriment.Personal and financial data arises not only from loans advanced but from any credit applications, successful or otherwise, with credit applications very much more numerous than loans advanced[ix]. Survey data suggests that a significant minority of users of online lenders were exposed to financial and data crime. 

The Pew Charitable Trusts[x] suggests that some 32% of all online lending users had experienced unauthorised withdrawals from their accounts (ie theft), overwhelmingly concentrated among users of digital illegal lenders. The associated financial damage ran into billions of dollars impacting millions of consumers annually.

Figure 1: Estimated range for scale and value of financial crime associated with online illegal lending in the USA[xi]

The political will and resource to tackle digital illegal lending varied considerably between states but even the most dedicated, focused and well-resourced were relatively ineffective and progress through the courts was painfully slow. 

Once a critical mass of Illegal lending had been reached, most US regulators simply lacked the resource, funding and expertise to tackle digital illegal lenders who tended in any case to mutate rapidly and stay one step ahead of regulators and intelligence and enforcement agencies. 

Even concerted action between federal agencies – including coordinated efforts to exclude bad actors from the payment systems – while initially impactful, failed to do more than slow the growth of digital illegal lending and the associated financial and data crime, and then only partially and temporarily.

Different states in the USA adopted different approaches towards reform and regulation, resulting in radically different outcomes for consumers, regulators and markets

There were digital illegal lenders operating in all US states. Some states were overwhelmed by illegal lenders with consumers suffering serious detriment within the credit market, while also being significantly exposed to financial and data crime. 

Other states had much lower incidence of digital illegal lending; consumers enjoyed cheaper credit, borrowed less, and less frequently, and experienced lower levels of problematic debt.  Consumers were less exposed to financial and data crime and thus also less damage to their financial welfare and resilience

Different approaches; different outcomes:

Some states banned small sum lending outright (characterised in Policis analysis as ‘Banned’ states)

Others adopted complex regulatory regimes, which aimed to eliminate all potential avenues to consumer detriment, often reinforced by a regulatory database to ensure compliance (characterised by Policis in subsequent analysis as ‘Complex restrictive’ states

Others put in relatively simple regimes which aimed to balance access to credit with enabling authorised (typically large, often listed) licenced lenders to operate at scale and with just sufficient profitability to support a viable, sustainable business with sophisticated automated systems to ensure compliance.

Lenders were held to high standards of conduct, often accompanied by relatively strict control of key dimensions such as price, re-financing and loan frequency and value.  (characterised by Policis in analysis as ‘Simple inclusive states’)

Consumer and market outcomes of different regulatory approaches

Consumer and market outcomes rested on the relative balance between authorised and unlicensed lenders in the various states, with those consumers in states where illegal lenders had a high market share suffering worse outcomes than in states where illegal lenders share was lower.

Banned states: In those states that banned small sum credit, use of small sum loans was only marginally lower (24%) than their share of the US sub-prime credit population (29%) would suggest.‘Banned’ states represented a disproportionate share (37%) of all digital illegal lending whilst suffering the worst outcomes of all US states, in their credit experience and exposure to crime, with the highest damage to their financial welfare. 100% of small sum online loans in these states were illegal.

Complex restrictive states: Consumers experienced significantly worse outcomes across all dimensions than those in ‘Simple Inclusive’ regimes. Adverse outcomes included higher credit cost, more stretched affordability and higher problematic debt. Consumers in these states were also much more likely to be exposed to financial and data crime and suffered greater damage to their financial welfare as a result. Illegal lenders represented a 75% share of the small sum online loans market in these states.

Simple inclusive states: Consumers experienced lower credit costs, borrowed less and less frequently and were less likely either to suffer either problematic debt or exposure to financial or data crime. Illegal lenders represented a 35% share of the small sum online loans market in these states.

These outcomes are best Illustrated by the difference in outcomes between the large and populous states of California, a ‘simple inclusive’ regime and that of Florida, a ‘complex restrictive’ regime. 

Figure 2: Summary of complex restrictive and simple inclusive states[xii]

Regulator Regime	Complex restrictive states	Simple inclusive states
Illegal lenders share of small sum online credit marke	75%	35%
Cost of credit per $100 borrowed	$37	$26
Average loan value	$499	$419
Impairment rate (in debt collection, arrears, write off)	35%	20%

Nowhere is the downside of the credit exclusion created by complex regulatory regimes with multiple layers of restriction better illustrated than comparing the credit market and financial crime outcomes of the two large and populous states of California and Florida.

California’s relatively simple regime which maximises market access delivers clearly better market and consumer outcomes and achieves the regulators consumer protection goals whilst also stimulating competition.

Figure 3: Outcomes of the regulatory regimes in California and Florida [xiii]

Regulator Regime	USA [xiv]	California ‘Simple inclusive’ regime	Florida ‘Complex restrictive’ regime
Share online payday made by licenced lenders	41%	79%	16%
Share online payday made by unauthorised lenders	59%	21%	84%
Average cost of credit per $100	$32	$17.50	$34
Average loan values	$475	$381	$528
Problematic debt (impairment/write off rate)	24%	14%	35%

Figure 4: Financial crime outcomes for the US, California and Florida [xv]

Regulator Regime	USA   Legal/Illegal	California   Legal/Illegal	Florida   Legal/Illegal
Balance of legal to illegal lenders	41%/59%	80%/20%	16%/84%
Unauthorised withdrawals without consent, % loans impacted	32%	11%	37%
Cost of unauthorised withdrawals per head of borrowers	$325 – $590	$165 – $245	$545 – $820
Personal & financial data sold without consent, % of loans impacted	39%	12% – 14%	40% – 48%

Overall

The US experience, based on analysis of millions of loans transactions across the US states, provides compelling evidence that in a digital age demand cannot be eliminated by constricting supply. Where demand cannot be met by regulated supply, illegal lending will come in to fill a credit vacuum.

The very different experience of US states adopting different regulatory frameworks suggest that regulators were more likely to achieve their consumer protection goals while limiting opportunity for illegal lending with an approach that sought to balance optimising access to credit with ensuring that lenders held to high conduct standards, were able to operate at scale and could be sufficiently profitable to be viable, sustainable businesses.  

The data demonstrates that regulatory complexity may be particularly counter-productive in meeting regulatory goals and achieving positive consumer protection outcomes.

A view from Japan

The experience of Japan[xvi] confirms insights from the US. It also offers important additional insights. The Japanese experience confirms the learnings from the US in a number of critical respects.

• The impact of credit vacuums in creating market opportunity for illegal lenders
• The transformative impact of digital channels in enabling illegal lending to create and scale opportunities for bad actors
• The timescales for the development of a digital illegal lending market of significant scale from the point of major regulatory intervention, being approximately 7 years
• The difficulties in tackling a large illegal lending market once established 

The Japanese experience also offers valuable insights, distinctive to the Japanese context.  Some of the most important of these include:

• The limits of informal borrowing as a sufficient and sustainable alternative to formal credit
• The sheer scale of a long established illegal lending market 
• The potential for digital illegal lending to create opportunity for serious organised crime 
• The challenges arising in seeking to tackle and manage illegal lending and the approaches which have proved successful in mitigating and containing illegal lending
• The economic impact of engineering a significant shrinkage in a large credit market

A key learning point for the UK from the Japanese experience is the pathway into illegal lending for those excluded by credit market reform. In Japan, half of former borrowers were excluded, and the profile of the remaining borrowers moved upmarket, with the cost of credit falling, affordability improving and problem debt declining. The better off enjoyed cheaper credit and benefitted from higher conduct standards.

Both the GB research and contemporary survey evidence from Japan indicates that faced with exclusion from the market, low-income consumers aim to do without credit, forgo or save towards purchases, draw on savings, sell possessions and rely on informal loans from friends and family.

However, there is a hard limit on how long consumers can do without as credit plays such a critical role for low income households in managing finances and cash flow. The evidence is that in the absence of other options and access to legitimate credit an urgent need – for some – will be met by illegal lending.

A long established illegal lending market

Japan also provides a salutary example of how large illegal lending markets can become and how far credit vacuums present opportunity for organised crime. Japan has had a long history of illegal lending which developed to service unmet consumer needs after World War 2 as banks focused on commercial lending and rebuilding the Japanese economy.

Unlicensed lending grew over the years to the point that by the early 2000s ‘Yamikin’[xvii] (illegal/ criminal) lenders – although very much lenders of last resort and widely feared – had become an embedded feature of Japanese public life, operating at scale and across Japan. 

Yamikin lending was dominated by the Yakusa organised crime groups for decades. It largely served consumers or small business unable to borrow in the formal sector. For the Yakusa money lending represented not only an important profit centre but also a key channel for laundering the proceeds of criminal activities. 

Illegal lending in Japan has long been monitored, with enforcement the responsibility of a well-resourced and well-funded unit within the National Police Agency.

The consumer finance sector – a pressing need for reform

Over time a formal, non-bank ‘consumer finance’ sector developed in parallel to the unlicensed sector. By the early 2000s the consumer finance sector was dominated by a few large, listed lenders, known as ‘Sarakin’[xviii] lenders. 

Some of these lenders operated with woeful conduct standards with some aspects of debt collection and lending practice not dissimilar to those of the Yamikin, with these firms being hugely unpopular with the public. The relatively large consumer finance sector was thus in desperate need for reform.

By 2003, the year immediately before planning for credit market reform began in earnest, the consumer finance sector in Japan was a $100bn p.a. sector.

The significant market reforms introduced by the new FSA and enshrined in the 2006 Money Lending Business law, implemented in 2010, followed a series of earlier reforms. Over time the authorities had introduced occasional reforms of the consumer finance sector, on each occasion reducing the legal interest rate. Each time reform had led to a shrinkage of legitimate credit followed by a significant increase in illegal lending.  

In contrast to the US where the authorities were slow to recognise the scale of digital illegal lending, in Japan this history of illegal lending and long experience of regulatory intervention acting as a stimulus to illegal lending meant the authorities were highly conscious that market reform would need to be preceded by new legislation focused on combatting illegal lending.

By 2004 and the point of planning for the 2006 Money Lending Business Law therefore, the Japanese authorities had not only had many years of experience of seeking to manage and contain an illegal lending market in large part run by organised crime but were also keenly aware that reform would act to stimulate illegal lending. 

As a result, credit market reform was preceded by new deterrent legislation strengthening police powers and resource and significantly increasing sanctions and penalties, while also making it easier for members of the public to come forward. 

Despite this significant effort and new legislation such approaches had limited success. Both the increase in resource and the deterrent legislation had some success in slowing the growth of illegal lending and moderating the reach of serious organised crime.

Nonetheless it is clear that despite significant deterrence and very considerable resource illegal lending remained – and continues to be – a persistent feature of society.

In Japan informal lending began to break down within a few years, and after three years almost two thirds of former informal users were unable to borrow, and at this point turned, reluctantly, to Yamikin lenders.

Ten years on from the initial point of planning for reform (in 2014) contemporary survey data suggested that one in ten borrowers in Japan were using Yamikin lenders.

Tougher legislation strengthened the effectiveness of enforcement, but this was countered by increases in use of illegal lenders and the shift to online. Illegal lending remained resilient to enforcement action and stiff penalties which appeared insufficient to act as a deterrent or counterweight to the criminal opportunities and stimulus generated by a credit vacuum.

Such experience suggests therefore that, once established, it may not be possible to close down a large illegal lending market even with supportive legislation, strong deterrent penalties, and significant enforcement resource.

Japan has however enjoyed some successes in combatting illegal lending. The effort against illegal lending is conceived as part of the wider drive against organised crime. This latter initiative has sought to cut off criminal enterprise from funding and support, in part through greater cooperation with the banks and local authorities. 

The Police seeking to combat illegal lending were aided by broader efforts to reduce the reach of organized crime and closer cooperation with the banks, to some extent undermining the capacity of organized crime to access and exploit the financial system.

As elsewhere however, the emergence of digital channels has complicated both the intelligence and enforcement challenges, from the consumer perspective blurring the boundaries between apparently legitimate and illegal lending. It has also enabled criminal enterprise to reach new groups and further scale their operations.

Data and partnership-led approaches seeking to disrupt funding and access to payments infrastructure proved more effective than even draconian deterrence or sanctions. Close working partnerships with financial services providers to disrupt access to the financial system appeared to provide a partially effective hostile environment. Such approaches may act to mitigate the ability of organised crime to infiltrate the credit space and use illegal lending as a vector to wider financial crime.

A way forward on consumer protection and access to credit in a digital age

Taken together the experience of the US and Japan would appear to hold several lessons for the UK, most importantly the urgent need to develop and implement a decisive preventative strategy to protect vulnerable consumers from digital illegal lending and pre-empt its action as a stimulus to financial and data crime.

Perhaps the most important lesson for the UK is the rapidity of the growth of digital illegal lending once a tipping point had been reached and the potential scale of such lending once critical mass had been achieved.

The key lesson to take from international experience is that the UK appears to be approaching the tipping points that preceded rapid growth of illegal lending in other markets. International experience suggests that credit vacuums will lead over time to the growth of a potentially large and highly damaging illegal lending market. A credit vacuum of any scale is also conducive to the growth of financial and data crime, which already accounts for over half of all crimes in the UK.  

It would seem clear that deterrent legislation, stringent penalties, muscular policing and even coherent efforts to shut bad actors and criminal enterprise out of the financial system will not prevent the emergence of digital illegal lending and the associated cyber and economic crime nor will it be effective in tackling such a market once established.

The evidence from both the US and Japan appears to indicate that once established at scale digital illegal lending is very difficult to tackle and near impossible to eliminate.

Viewed from this perspective, there would not seem to be any conflict between maximising consumer protection and maintaining credit access for as wide a proportion of the population as possible.

The time for developing a preventative strategy on digital illegal lending in the UK is now! The window of opportunity to do so may be narrowing very quickly.

You can click below to read Anna and Martin’s full report.

Endnotes

---

[i]The data is not survey data or the output of a model and thus represents what actually happened in terms of consumer experience of taking out small sum loans online within different states, within differing state regulatory regimes and the outcomes of loans made by state licensed and non-state licensed lenders in those various states.

iioriginally undertaken by Professor Domoto then of the Tokyo University of Information Sciences over the course of a series of consumer surveys in Japan

[iii]Policis was fortunate to be able to research the US small sum credit market, digital illegal lending, consumer outcomes and the impact of different regulatory and enforcement approaches in the years 2010 -2014, following the establishment of the Consumer Financial Protection bureau in 2010.

[iv] These projects built on work previously undertaken for the UK Government covering both the impact of different international regulatory approaches on consumers and credit markets (Policis for DTI The impact of interest rate ceilings in other countries 2004) and on illegal lending in a UK context (Polics and PFRC Illegal lending in the UK 2006, Policis and PFRC for DTI Evaluation of the illegal money lending team pilot 2007, Policis for BIS Interim Evaluation of the National Illegal Money Lending team 2010). 

[v] Some of which later established operations in the UK and were instrumental in the growth of the UK payday market in the years prior to the establishment of the FCA and market reform.

[vi] The US research was based on highly robust data, drawing on some 10.4 million small sum loan transactions contained in the leading US sub-prime credit reference database. Each loan was identified by both the state of residence of the borrower and the regulatory status of the lender within each state, plus a wide range of other data

[vii] A mix of offshore lenders making loans into the US (40%) and tribal lenders operating out of tribal lands and claiming immunity from state licensing laws on sovereign nation grounds. 

[viii] This finding was echoed by the Pew Charitable Trust in 2014  which found that “Aggressive and illegal actions are concentrated among the approximately 70% of lenders that are not licensed to lend in all the states where they lend.

[ix] The US credit reference data on which we relied for analysis was based only on loans actually made. We were not  therefore able to calculate how many credit applicants might have been impacted.

[x] The Pew Trust 2014 report into online payday lending. http://www.pewtrusts.org/~/media/assets/2014/10/ payday-lending-report/fraud_and_abuse_online_harmful_practices_in_internet_payday_lending.pdf

[xi] Policis analysis of credit reference data, Pew trust survey data of online small sum borrowers (2014) and Stephens inc data on scale of US online lending

[xii] Policis analysis of Credit Reference Data (2012)

[xiii] Policis analysis of credit reference data 2012 and Pew Trust survey data of online small sum borrowers 2014

[xiv] Base: All payday loans made online to state residents by both state licenced and unlicenced lenders  

[xv] Policis analysis of credit reference data 2012 and Pew Trust survey data of online small sum borrowers 2014

[xvi] It would seem important to emphasise that the Japanese reform is widely regarded, both domestically and internationally, as a resounding policy success

[xvii] A contraction of Yami (darkness ) and kinyu (finance)

[xviii] Both the Yamikin and Sarakin lenders were public hate figures, both of whose outrageously aggressive debt collection tactics generated a series of public “scandals”, typically involving the suicide of beleaguered borrowers. The resulting public outrage ultimately generated unstoppable momentum for reform.