Exploitation is about use of information

THROUGHOUT history, moneylenders have attracted opprobrium — from Shylock’s demand for a “pound of flesh” to the vilification of the banking industry following the subprime crisis.

The current international spotlight is on payday lenders such as Wonga, which are facing regulatory and public criticism for their high costs of borrowing.

Locally, unsecured lending has attracted significant criticism. From African Bank to the township “mashonisas”, lenders are accused of being unscrupulous and exploiting clients.

There is an obvious response to such criticism: lending transactions are voluntary. Clients know what they are getting into, or they can find out.

The availability of loans is partly about access to finance, a long-time political objective in SA. Lending is often advantageous: many businesses wouldn’t be able to open without finance and many individuals wouldn’t be able to invest in their education. For every borrower who blows the cash on a short-term binge, there may be another who invests it wisely to more than cover the cost of the loan.

With lending, it is difficult to decide where exploitation exists and where it doesn’t. That was the message of Shakespeare’s Merchant of Venice, in which Shylock was both victim and villain.

Karl Marx’s influential definition of exploitation is the denial to workers of the surplus their labour generates.

Placing such a definition in the context of lending would have it that lenders unfairly extract a portion of borrowers’ wealth. We are often vague on what is unfair, but high interest rates usually attract outrage. One can easily defend these rates where loans are small and origination costs high. Interest rates need to capture the cost of making the loan as well as the risk of default.

Certain types of loan come with high default rates and are expensive to make, but we still consider them good loans.

However, the defence that lending is a rational economic transaction is pretty thin. We know that clients are often not rational. Behavioural finance studies show that most people place too much emphasis on immediately satisfying their wants, even though they know they will spend a long time paying for them. In the parlance of behavioural finance, we are all prone to “intertemporal choice”: we demand instant gratification without thinking much of the long-term cost; eat, drink and be merry, for tomorrow we may die. That applies just as much to eating a piece of cake as it does to taking out a loan.

Studies have shown such decisions are influenced by everything from the words used in describing the loan, to glucose levels in the decision-maker’s blood. Lenders know people are bad at intertemporal choice and can exploit it.

This, to me, is the source of our sense of lending exploitation. It is a sense different to Marx’s.

Exploitation arises not from the allocation of excess, but from the information asymmetry held by each party to the deal. The lender knows how to rationally discount money across different periods and the borrower doesn’t.

Lenders can make this worse by heightening the borrower’s irrationality, by emphasising the benefit of taking the money immediately, by encouraging a decision before the borrower can think more soberly. We call out high interest rates because we think some simply can’t be justified as rational and that the borrower must have been exploited.

This analysis of exploitation

Lenders exploit intertemporal choice, and this is the source of our sense of lending exploitation

has clear policy implications.

Behavioural economist Richard Thaler and legal scholar Cass Sunstein have written a book entitled Nudge, on how states can intervene to get us to make better decisions. They call their position “libertarian paternalism” — give people freedom of choice, but intervene with information and guidance to ensure it’s the right choice.

Applying this to lending, interventions might include making lenders offer standardised products so customers can easily compare. One can slow transactions so customers have time for second thoughts — “cooling-off” periods.

Much can also be done by dictating what information must be disclosed and what weight to attach to it.