[The People's Loan Cliff] Side Effects Every Time the Maximum Interest Rate Is Lowered... The Betrayal of a 'Good Policy'

Loan Companies, Low-Credit Borrowers' Loan Share Drops from 64.5% to 52.8%
Illegal Money Lending Experience in Japan Increases 7-Fold Due to Interest Rate Cuts
Experts Say "Flexible Application Needed According to Market Economy Conditions"

[Asia Economy reporters Kwangho Lee and Seungseop Song] The growing concerns about the side effects of lowering the legal maximum interest rate stem from the repeated "balloon effect," where low-credit borrowers are pushed out of the formal financial system each time the maximum interest rate is reduced. In fact, when the legal maximum interest rate was lowered to 24% per annum in 2018, about 50,000 people were unable to obtain loans from the formal financial sector and were driven to illegal private loans. Although financial authorities introduced supplementary measures, they were insufficient. Last month, the financial authorities proposed alternatives such as strengthening mid-interest loans, but there are forecasts that the "betrayal of good policies" will repeat.

The Paradox of Good Policies: Financial Refugees May Increase

According to data received by Yoon Chang-hyun, a member of the National Assembly's Political Affairs Committee from the Financial Supervisory Service, among the personal credit loans amounting to 34.547 trillion KRW from the top 10 lending companies, 95.7% (33.046 trillion KRW) are loans with an annual interest rate of 20% or higher. The reason why lending companies have many high-interest loans above 20% per annum is due to their cost structure. Currently, the average funding cost for lending companies is about 6%. Since they cannot raise funds from commercial banks, they borrow expensively from savings banks and capital companies. As their main customers are low-credit borrowers (grades 7 to 9), the bad debt cost (unrecoverable loans) is about 10%, and operating costs such as management fees and loan broker commissions amount to 7% of the loan amount. The total cost is about 22-23% of the total loan amount.

The lending industry argues that to break even, the minimum loan interest rate must exceed 20%. Structurally, if the maximum interest rate is lowered, they will have to either cease operations or selectively lend only to relatively sound customers among low-credit borrowers.

Lending companies have been continuously reducing the proportion of loans to low-credit borrowers. In 2018, excluding those among the top 10 companies that did not engage in new business, low-credit customers accounted for 64.5% of the total. This proportion slightly decreased to 63.3% in 2019 and sharply dropped to 52.8% last year. Looking at individual companies, those that secured over 70% low-credit borrower ratios two years ago have disappeared, and most maintain between 40-60%. Some companies have a low-credit loan ratio as low as 14.2%.

Similar side effects were found in a research report by the Korea Institute of Financial Services for the Underprivileged analyzing the impact of lowering the maximum interest rate from 27.9% to 24%. According to a survey conducted in March targeting low-credit borrowers and lending companies, the number of new loan applications and approved customers sharply declined over time after the interest rate reduction. New credit loans also saw a 41.9% rate of re-loans focused on existing customers, an increase of 23.9 percentage points from the previous year, and 16.3% reported halting all credit loans, a 9.7 percentage point increase. If the maximum interest rate is lowered to 20%, 36.4% of companies said they would consider selling or closing their business, and 26.2% said they would downsize operations through workforce reductions and restructuring.

Japan Also Faces Side Effects of Interest Rate Cuts... Ultimately, Vulnerable Groups Suffer

The damage ultimately falls on vulnerable groups with low credit ratings and difficult circumstances. Despite the reduction in the maximum interest rate, older people, those with uncertain income sources, and those with poor credit still had high usage of illegal private loans. Vulnerable groups who entered illegal private loans due to rejection by lending companies were enduring exorbitant interest rates. Among survey respondents, 69.9% paid interest rates exceeding the legal limit, and 30% paid interest exceeding the principal within one year. An estimated 12.3% of respondents bore interest rates of 240% or more annually.

The aftereffects of lowering the maximum interest rate are also evident in Japan’s precedent when similar measures were implemented 10 years ago. Japan sharply lowered the maximum interest rate under the Investment Law from 29.2% to 20% per annum starting June 2010. According to the "10 Years of Market Changes After Strengthening Regulation of Japan’s Money Lending Industry" report by the Credit Finance Research Institute, the number of registered money lending companies dropped by 73.3% to 1,647 as of March last year compared to March 2009. The Japan Financial Services Agency reported that the number of illegal money lending users increased more than sevenfold since 2010.

Reports and consultations received by the Financial Supervisory Service’s Illegal Private Loan Victim Reporting Center are steadily increasing. At the end of last year, the total number of cases was 128,538, an increase of 12,916 cases (11.2%) compared to 2019. In particular, illegal private loan cases surged by 47.4% to 7,351. There are concerns that lowering the maximum interest rate could fuel illegal private loans, which have been rampant amid the COVID-19 pandemic.

Experts argue that since the interest costs borne by illegal private loan users are not only economic but also social costs, it is necessary to reconsider policies focused solely on lowering rates. Professor Kim Dae-jong of Sejong University’s Department of Business Administration said, "For small business owners or self-employed individuals, the important factor is not low interest rates but whether they can borrow within the formal financial system," and advised, "A flexible approach that adjusts to the current market economy situation, where the maximum interest rate has been continuously lowered, should be introduced." Oh Jung-geun, president of the Korea Financial ICT Convergence Society, criticized, "The most concerning group due to the maximum interest rate reduction is the financially vulnerable," and said, "The plan to lower the rate to 20% should be reconsidered from scratch even now."