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Consumer Credit Law Review. Part 1 Setting the Scene [1999] NZAHGovDP 2 (1 June 1999)

Last Updated: 18 April 2020

CONSUMER CREDIT LAW REVIEW

PART 1 SETTING THE SCENE









JUNE 1999






ISBN 0-478-23430-9








Level 8, Ministry of Commerce Building

PO Box 1473, Wellington
Tel: 04 474 2750
Fax 04 473 9400

CONTENTS

1. INTRODUCTION

The market for consumer credit in New Zealand is large and amorphous. In fact, it is more helpful to think of the overall ‘market’ as being composed of a series of market segments, each having its own distinguishing characteristics.

Since the publication of the 1988 document, Consumers and Credit^[1], the Ministry of Consumer Affairs has played a key role in introducing various innovations to credit legislation, in order to make the credit market for consumers work in a more effective way. Nonetheless, the approach has been piecemeal: in contrast with other industries there has been no major overhaul of credit legislation since the Credit Contracts Act 1981.

That the regulatory framework for consumer credit has become outmoded is now widely acknowledged. For this reason, in March 1999 the Minister of Consumer Affairs instructed officials to undertake a review of consumer credit policy and legislation. The justification for the review is based on impediments to efficiency and the quality of regulation issues, as well as consumer detriment. The task lying ahead is to deal with these issues in a thorough and timely manner.

This document is the first in a series to be released for public consultation. In setting the scene for the review, it summarises the current regulatory framework for consumer credit, leading into a discussion of appropriate goals for a framework. Following this is an attempt to unravel the market and provide an overview of its shape and the determinants of its structure as well as, where possible, estimates of the size of the key market segments.

The justification for regulatory intervention is dealt with in some detail in the paper. Through employing a dual economic analysis, it is argued that there are several likely elements of market failure, as well as equity concerns, in the market for consumer credit. Nonetheless, it is concluded that this offers only a prima facie case for intervention: the net gains from any proposed intervention need to be clear.

Consumer credit can contribute to the welfare of consumers and the prosperity of business, but only if certain conditions are met. For this reason, consultation will be at the core of the review process. We encourage you to make your views available to us and we look forward to your response.

2. REVIEW PURPOSE

2.1 GENERAL FOCUS

There have been no major changes to consumer credit law since 1981, when the Credit Contracts Act came into force. Since that time, however, there has been significant technological and economic change, which has impacted heavily on the consumer credit market.

Consumer credit law has been a target of widespread criticism since 1981^[2]. This criticism is based on various considerations, including:

• complexity of the law, particularly the Credit Contracts Act
• fragmentation of the law across a number of statutes, resulting in unnecessary duplication as well as inconsistencies
• difficulties in enforcing the law
• unfairness to consumers under some provisions, such as the “rule of 78” method for calculating early repayment rebates; the use of nominal, rather than effective, interest rate calculations; and the exclusion of certain charges from the finance rate
• unnecessary compliance costs for lenders and business borrowers in some circumstances (e.g., under controlled credit contracts).

2.2 PURPOSE OF THE REVIEW

The purpose of the review is to identify an appropriate regulatory regime for consumer credit. In particular, it will focus on:

• the relevance of existing law to consumer credit transactions
• the scope for simplifying the law
• ways to strengthen compliance and enforcement
• identifying specific legislative provisions that cause detriment.

2.3 KEY ISSUES TO BE ADDRESSED

The following issues will be explored in greater detail as the review progresses. They will form the subject of specific consultation documents.

2.3.1 Application of Consumer Credit Law

How can consumer credit law be appropriately targeted, so that those, and only those, who need consumer protection are covered?

Do small businesses need consumer protection when borrowing?

Should there be a money limit on credit legislation, or should its application be defined by the purpose for which the credit is used?

2.3.2 Achieving Transparency in Consumer Credit

What information should be disclosed by lenders under a credit contract (including hire purchase and other related contracts) and how should it be presented?

For which credit products should finance rates be maintained?

Can the law provide incentives for lenders to provide clearer, plain English contracts?

What method of calculating interest rates is fairest for consumers?

2.3.3 Redress and Enforcement

Are the redress provisions under current law adequate and, if not, how can they be improved?

What incentives do lenders need to properly comply with credit law?

Is the test for oppression under the Credit Contracts Act working adequately for consumers? If not, how might it be enhanced?

2.3.4 Other Issues

What rules should credit law provide in relation to rebates for early repayment of a credit contract?

How should insurance under a credit contract be regulated?

Is it a function of credit law to consider consumer over-indebtedness?

How can the law (particularly the Hire Purchase Act) be made consistent with the new personal property securities legislation?

What issues are raised by the development of electronic commerce?

What other issues related to consumer credit should the Ministry of Consumer Affairs include in its review?

3. WHY THE MINISTRY OF CONSUMER AFFAIRS IS CONCERNED WITH CONSUMER CREDIT

3.1 DEFINITION OF CONSUMER CREDIT

In simple terms, ‘credit’ comes about when the payment of a sum owed by one person to another is deferred, or when one person incurs a deferred debt to another. Obviously, credit transactions occur in many contexts. From both practical and policy perspectives, however, it is useful to distinguish between ‘consumer’ credit and ‘commercial’ (or business) credit^[3].

Consumer credit is defined generally as being credit provided under a contract to a natural person who uses it, or intends to use it, predominantly for personal, domestic or household purposes (such as a television bought on hire purchase, a loan to purchase a residential home, or a secured or unsecured loan used for a holiday). For the present purpose we are concerned only with credit provided by a lender in the ordinary course of, or incidental to, the business carried on by that lender. We are not concerned with private lending arrangements between natural persons.

3.2 IMPORTANCE OF CONSUMER CREDIT

Many goods and services are purchased via a consumer transaction that is partly or completely financed by credit. Without credit such purchases would not occur, and consumers and businesses would be worse off. Thus, accessible consumer credit can make a significant contribution to the welfare of consumers and the prosperity of business. However, the particular difficulties consumers face when transacting in the credit market (as discussed in Chapter 7) mean that credit transactions can also result in consumer detriment. The Ministry of Consumer Affairs, with its remit to promote a fair and informed market place where transactions are efficient, has an interest in ensuring that the law on consumer credit meets the needs of all transactors.

Consumer credit has two central characteristics that are not present in many other consumer transactions:

• often three parties are involved; a consumer, a seller of a good or service, and a credit provider
• the provision of consumer credit always involves transfers that take place at different points in time, so it is harder for those involved to ensure that the elements of the agreed transaction are fulfilled.

New Zealand regulates consumer credit under specific consumer-oriented credit statutes, as well as statutes covering more general consumer transactions. The use of specific consumer credit statutes also occurs in the jurisdictions that New Zealand usually compares itself with: Australia, the United Kingdom and Canada, as well as the United States and the countries of the European Union. Alternative means of dealing with consumer credit, such as reliance on the common law or on more general, business-oriented credit statutes, have not proved adequate for the special circumstances of consumer credit.

The Ministry of Consumer Affairs sees its task as evolving and improving the existing regulatory regime rather than advocating a radical new approach. As the last major reform occurred in 1981 with the introduction of the Credit Contracts Act, the Ministry sees a need for a comprehensive review, to which this document, and the submissions to it, can provide an initial contribution.

4. LEGISLATIVE FRAMEWORK AND COMPLIANCE COSTS

A number of acts regulate consumer credit. Some, like the Credit Contracts Act and Credit (Repossession) Act, are comparatively generic, while others, like the Hire Purchase Act, regulate specific transactions. This section briefly describes each Act that has a significant impact on the credit market. It also discusses the issue of the compliance costs arising from the regulation that are placed on lenders.

4.1 CREDIT CONTRACTS ACT 1981

The main features of the Credit Contracts Act are that it requires disclosure of both the terms of the credit contract and the cost of credit, allows the Court to reopen an oppressive contract, regulates advertising of credit and prohibits the inclusion of certain punitive terms in credit contracts^[4]. The Act is self-enforcing.

The disclosure requirements relate only to controlled credit contracts. Certain credit contracts are controlled, with the primary intention of protecting the least sophisticated borrowers, thus giving the Credit Contracts Act its consumer orientation. Controlled credit contracts are those offered by a financier acting in the course of the financier’s business, or a credit contract introduced or prepared by a paid advisor. Excluded are contracts where the debtor is a financier, the Crown, a local authority, or a body corporate with a paid-up capital of not less than $1million, and where the amount lent is over $250,000.

4.2 HIRE PURCHASE ACT 1971

The Hire Purchase Act regulates a particular type of sale whereby a seller transfers possession in a good and finances (often via a third party financier) its purchase by the buyer. However, the seller or financier retains ownership of the good until the purchase price and the cost of credit have been repaid in full.

4.3 CHATTELS TRANSFER ACT 1924, MOTOR VEHICLE SECURITIES ACT 1989

These acts are not strictly consumer protection legislation but, because many forms of consumer credit are based on security arrangements, they are directly relevant. They establish a registration system and a system of priorities for the taking of security by a financier over personal property (Chattels Transfer Act) and motor vehicles (Motor Vehicle Securities Act). They are to be repealed once the Personal Property Securities Bill becomes law.

4.4 CREDIT (REPOSSESSION) ACT 1997

The Credit (Repossession) Act 1997 has been in force since 1 July 1998. The Act standardises procedures for repossessing goods given as security for credit. It covers the repossession process that a creditor or agent must follow for all secured loans and hire purchase agreements.

4.5 DOOR TO DOOR SALES ACT 1967

This act establishes specific disclosure rules, and provides a seven-day cooling off period, for credit contracts that are made via a door-to-door sale.

4.6 PROPERTY LAW ACT 1952

The Property Law Act 1952 regulates mortgages and creditor remedies when security has been taken over real property. The Ministry does not intend to review remedies under the Property Law Act^[5].

4.7 RECENT CHANGES TO CREDIT LAW

Reforms that have been passed recently are:

• The Credit Contracts Amendment Act 1998, which became effective on 1 March 1999. It gives guarantors the same rights to information about the contract as the borrower. Section 35 of the Credit Contracts Act 1981 has now been repealed so that misleading credit advertising is subject to the Fair Trading Act 1986.

4.7 cont’d

• The jurisdiction of Disputes Tribunals was recently extended to cover the disclosure provisions of the Credit Contracts Act 1981, including remedies for failure to make proper disclosure, and any of the Courts’ powers under the Hire Purchase Act 1971.

4.8 PERSONAL PROPERTY SECURITIES BILL

The Personal Property Securities Bill has been introduced to Parliament and is currently before the Commerce Select Committee. It will simplify the notoriously complex area of registration of personal property securities by repealing the Chattels Transfer Act and the Motor Vehicles Security Act. It will also add new expressions to the terminology used in the general area of credit and securities law. A “hire purchase” for the purpose of the Bill is a species of “purchase money security interest”, which means that a separate definition of “hire purchase” under the Hire Purchase Act is redundant for most purposes.

4.9 COMPLIANCE COSTS

The current regulatory framework imposes significant compliance costs on lenders. Much of this burden is inevitably borne by consumers, depending on the extent to which lenders can pass on these costs. The compliance cost issue, however, is not necessarily straightforward. One view within the industry is that much of the current regulation has resulted in heavy front-end costs, but that the ongoing costs of meeting the regulatory requirements are lower than is commonly supposed.

Another argument is that the regulatory framework of the 1980s has become much less relevant in the 1990s to ‘reputable’ lenders (such as the banks and other large financial institutions surveyed in the Reserve Bank Household Claims Series). A number of sources believe that in this modern era some regulations have become unnecessary and cumbersome.

This argument is based on four assertions:

• the existence of vigorous competition among mainstream lenders
• the working of an effective self-regulatory framework (the Banking Ombudsman scheme)
• a more consumer-friendly range of products (such as flexible mortgages)
• ‘reputation as a regulator’: the importance of maintaining a ‘good corporate citizen’ image, which reinforces good business practice and ethical conduct across the market.

If this argument is tenable, then an assessment of the relative costs/consequences of easing the regulatory regime for the mainstream segment of the market may be warranted. For example, there may now be little, if any, justification for applying many of the provisions of the Credit Contracts Act to transactions between businesses.

This leaves open the question of what is an appropriate regulatory regime for institutions of a different nature: the cash-loan companies/marginal lenders. Considerable anecdotal evidence suggests that, in spite of the current regulatory regime, there is still a significant

4.9 cont’d

level of questionable practice and consumer detriment within this segment of the market. If problems concerning bad business practice/unethical conduct are shown to be widespread, then an appropriate policy response may lie in improving consumer education as well as bolstering redress and enforcement measures.

A major problem in the design of any intervention is that transaction circumstances vary greatly by market segment. The New Zealand credit market is becoming increasingly segmented. A regime that is likely to be satisfactory for the mainstream parts of the market (where supplier reputation has a crucial role) may be inadequate for dealing with transactions on the ‘fringe’. Conversely, a regime that deals effectively with ‘fringe’ transactions may involve higher than necessary compliance costs for mainstream transactions. ‘Fringe’ transactions are typically more problematic, and so the balance of any regime is likely to be oriented more towards this segment of the market.

Undertaking the review will allow the Ministry of Consumer Affairs to assess the most suitable mix of policy measures, so that effective regulation is maintained in the various market segments, while keeping transaction and compliance costs at an acceptable level.

Is there any merit in distinguishing between mainstream and marginal lenders when considering future legislative proposals? To what extent would such an approach be desirable?


Are there any other specific problems with the operation of the credit market that are not currently addressed by legislation? Please detail.

5. THE GOALS OF CONSUMER CREDIT LAW

In the broadest sense, the Ministry submits that consumer credit law should seek to achieve the following goals:

• promote efficient credit markets that are conducive to voluntary transactions (see 5.1)
• require effective information disclosure, so that:
  • − consumers can distinguish between different credit products and, as far as possible, make rational choices between those products and cash purchases
  • − consumers are adequately protected from deception (see 5.2)
• allow for innovation in the design of credit products (see 5.3)
• provide adequate incentives for compliance with the law by all parties to a credit transaction (see 5.4)
• discourage oppressive conduct by lenders (see 5.5).

5.1 PROMOTE EFFICIENT CREDIT MARKETS THAT ARE CONDUCIVE TO VOLUNTARY TRANSACTIONS

This goal focuses on further enhancing the competitive environment for the provision of credit and minimising transaction costs incurred by borrowers and lenders. It is a broad goal that focuses on law that is workable, accessible, understandable and enforceable, and which will allow consumers to bargain and transact freely with lenders.

5.2 REQUIRE EFFECTIVE INFORMATION DISCLOSURE, SO THAT:

• consumers can distinguish between different credit products and, as far as possible, make rational choices between those products and cash purchases
• consumers are adequately protected from deception

This goal underpins disclosure or “truth in lending” requirements. The premise is that competition among lenders is enhanced by the informed use of credit. Credit law should attempt to assure meaningful disclosure of certain credit terms, so that consumers can:

• compare more accurately and easily the various credit terms available
• avoid the uninformed use of credit
• be reasonably protected against misleading and unfair practices^[6].

5.2 cont’d

Measuring the cost of credit is fundamental to making reasonable comparisons between the alternatives and, therefore, is necessary for competition to work well. It can benefit the consumer in two important ways:

(1) help the consumer to decide whether to use credit
(2) assist the consumer to find the least expensive, most suitable credit
(3) it may also send a warning signal to a consumer if the cost of credit is unusually high.

If the law provides no reasonable basis for comparison, information asymmetries between borrowers and lenders may reach a level where effective competition and, hence, efficient outcomes are compromised.

5.3 ALLOW FOR INNOVATION IN THE DESIGN OF CREDIT PRODUCTS

The law should allow for innovation and flexibility, so that lenders can respond to changing consumer needs and preferences. The development of flexi-mortgages and credit card innovations are examples of product innovations that have proven popular with consumers and profitable for businesses. Innovation may enable lenders to develop more cost-effective ways of delivering credit products.

Nonetheless, unrestricted flexibility for lenders may take away the basis for comparison between products and, therefore, raise the informational and search costs for consumers, often without any compensating advantages. It is acknowledged that a trade-off between standardisation of credit terms (for comparison purposes) and the encouragement of innovation is likely. An important aim of credit law is to ensure that the terms of the trade-off are acceptable.

For instance, consider the appropriate regulation for calculating interest rates on a credit contract. The goal of innovation would suggest that any method of calculating an interest rate should be allowed. However, this could confuse or mislead consumers who are choosing between credit products: two products may state the same interest rate, but the amount actually paid for each may be different^[7]. Another alternative is to require that the method used is disclosed; but such disclosures are likely to become so complex that they are of little value to consumers. Therefore, regulation usually prescribes the method for calculating interest, even though this may constrain innovation.

5.4 PROVIDE ADEQUATE INCENTIVES FOR COMPLIANCE WITH THE LAW BY ALL PARTIES TO A CREDIT TRANSACTION

Consumer credit regulation will not be effective if it does not contain adequate incentives for all parties to comply with it. Parties have a financial incentive to comply with the law whenever the cost of compliance is less than the perceived cost of non-compliance.

Failure to comply with the law may result in penalties or civil liability, or the loss of licence or ability to trade (the Credit Contracts Act 1981 includes a negative licensing provision). For consumers, it includes the possibility of repossession and the imposition of penalty interest.

In addition, there can be consequences of a less tangible nature; for example, damage to reputation, reduced likelihood of repeat business and, for consumers, negative credit ratings.

The task of policy makers is to consider whether the market provides sufficient incentive for compliance by all parties. If regulation is required, it must be appropriate, well designed and enforceable in order to achieve compliance.

5.5 DISCOURAGE OPPRESSIVE CONDUCT BY LENDERS

Traditionally, consumer credit policy has been concerned to discourage usury, deception and other forms of oppressive conduct, such as realising excessive amounts of security.

This goal recognises that there is a major imbalance of knowledge and power between lender and borrower. Therefore, internationally, most credit statutes provide post-transaction remedies for the consumer, such as the ability to apply to a court to have transactions overturned in situations of oppressive conduct. Limits are also placed on the coercive powers of creditors and their agents, most notably repossession agents.

5.6 OTHER GOALS

Macroeconomic and social policy considerations relating to credit are largely outside the scope of the proposed review. It is our view that broader goals, such as reducing personal indebtedness (including bankruptcy filings) and dealing with poverty, are more appropriately dealt with by other policy instruments.

Are these realistic and relevant goals for consumer credit law? If not, why not? Are there other goals for consumer credit that should be considered? If so, what are they?

6. SHAPE OF THE CONSUMER CREDIT MARKET

6.1 CHANGES IN THE STRUCTURE OF CONSUMER CREDIT

Since 1981, when the Credit Contracts Act came into force, consumer credit transactions have become much more numerous. Today, consumers use credit for purchasing a wide variety of commodities. New electronic technologies have facilitated the introduction of credit products, ranging from credit cards to flexible mortgages. As well, from the mid-1980s public policy shifted from using control over consumer credit as a separate policy instrument to incorporating it as part of overall monetary policy, without discriminating directly between the various types of credit. This policy change released a suppressed demand for consumer credit, while leading to major structural changes in its supply. Most New Zealanders now have relatively easy access to consumer credit through a housing loan, credit card, or hire purchase arrangement, on conditions convenient to themselves and to lenders.

6.2 CONSUMER CREDIT AS A SPECTRUM OF INTERDEPENDENT MARKETS

Conceptually, at the heart of the consumer credit market is the notion of an ‘annual percentage rate’ (APR). The APR includes the interest payment, a risk premium (and profit), the administrative costs of the contract, plus (as an average) the costs of redress for those cases where loan repayments do not take place as contracted, and other costly measures, including debt write-off. These factors are all adjusted for the time element in the transaction.

Costs will vary from transaction to transaction. This means that there is no single price of consumer credit, but rather a spectrum of APRs reflecting different transaction circumstances. Thus, there is a spectrum of partially interdependent markets for consumer credit that can be ranked according to their APRs, as shown below. The horizontal axis of the graph ranks the various consumer credit transactions in the spectrum. The vertical axis reflects the APR for each transaction.

Fig .1 CONSUMER CREDIT MARKETS AND THE COST OF CREDIT

APR %

←Market A→ ←Market B→
←Market C→ ←Market D→

Consumer Credit Transactions

6.2 cont’d

Figure 1 above suggests that the overall market can be simplified into four separate market segments:

• Market Segment A is characterised by reasonably large transactions secured against secure and tangible assets (usually mortgages supplied by banks and other mainstream financial institutions)
• Market Segment B is characterised by smaller-sized transactions secured against the credit-worthiness of the borrower (usually credit cards supplied by specialist mainstream financial institutions, often attached to banks)
• Market Segment C is characterised by moderate-sized transactions secured against less-secure assets than housing (usually hire purchase supplied by specialist mainstream financial institutions, often in co-operation with the retailer). Market Segments B and C overlap to some extent
• Market Segment D is characterised by variable-sized transactions (usually within the range of $200 to $10,000) to people with poor credit records or few assets (usually provided by fringe financial institutions).

There is no comprehensive information on the size of the New Zealand consumer credit market or of the individual market segments. In spite of this information deficit, and the complexities in drawing international comparisons, the weight of evidence suggests that consumer debt levels in New Zealand are not out of line with comparable OECD countries.

The biggest group of consumer lenders is encapsulated in the Household Claims Series of the Reserve Bank^[8]. This Series includes the major retail banks and various other sizeable household lenders; in total, about 25 institutions^[9]. Falling outside the coverage of the Series are a number of smaller institutions, such as small building societies and finance companies, credit unions, stock and station agents, marginal lenders/cash loan companies and some firms of solicitors and accountants who lend money on behalf of their clients. (The latter is now a much diminished activity relative to its significance in the 1970s.) In addition, a relatively recent development in household financial liabilities has been student loan debt, which totalled $1.9 billion as at 30 June 1998 and is currently increasing at a rate of $560 million per annum.

The banking system is today characterised by a high degree of foreign ownership (particularly Australian), which provides strength for the system by giving local banks access to both capital resources and banking expertise. The industry is highly competitive and institutions have been free to develop in areas in accordance with their comparative advantage. In fact, today’s banking sector owes much to the deregulation of 1984. Following this deregulation, the number of registered banks increased significantly, partly through non-bank financial institutions gaining registered bank status and partly through an inflow of foreign banks. Conversely, the number of non-bank financial institutions fell in


6.2 cont’d

number as most of the larger ones became banks, while some banks which owned separate finance companies incorporated these operations within the bank itself^[10].

Broadly, banks provide credit in the form of loans secured by mortgage and credit cards, as well as personal loans and overdrafts. Non-bank financial institutions generally lend to households by way of mortgage loans, hire purchase or other forms of personal lending. There are two important exceptions. First, stock and station agents advance credit on the basis of forthcoming crops/stock so that, for example, farmers can bring forward some of their consumption after a bad season. (The agents specialise in selling what is effectively the collateral.) This is important to rural communities, but banks are not keen on this type of lending since it requires expertise in a specialised area of risk management: assessing the security on, and creditworthiness of, livestock and crops.

Second, marginal lenders (notably the cash loan companies) specialise mostly in personal loans secured against personal property. Typically, these lenders operate in suburban centres and small towns, offering credit from $200 to $10,000. Clients often come from immigrant communities and low-income sectors whose access to mainstream borrowing is limited. Some hire purchase financiers, particularly in the used-motor vehicle market, may also be classified as marginal lenders.

Home mortgages are the largest category of consumer credit. At the end of 1998, outstanding housing loans from institutions surveyed by the Reserve Bank totalled $54.1billion. This compares with $2.1billion outstanding on credit cards: bank, American Express and Diners Club at that time. (There is a considerably smaller, but unknown, amount outstanding on ‘store’ credit cards.) Further, there is an estimated $1.0-1.5billion outstanding on motor vehicle loans not secured by mortgage (mostly hire purchase) and perhaps another $1.0billion for furniture and appliances.

Contrary to popular opinion, credit card debt has not grown any faster than other household debt in New Zealand over the last few years. In fact, for the five-year period from December 1993 to December 1998, outstanding claims on credit cards (excluding store cards) increased by about 80 percent in nominal dollars; a rate similar to that of outstanding claims on non-credit card household debt surveyed by the Reserve Bank^[11].

6.3 INNOVATIONS IN THE MAINSTREAM CONSUMER CREDIT MARKET

6.3.1 Mortgage Innovations

From the viewpoint of consumers, a very significant innovation through the 1990s has been the flexible use of table loans secured by mortgage. It has become possible to top up an existing mortgage or support another loan on the same security. Also, there has been growth in fleximortgage/revolving credit products. Essentially, these provide the borrower with a credit limit and, usually, a minimum monthly repayment, but place few or no constraints on what the credit may be used to purchase, or when. For instance, a fleximortgage with a credit limit of $100,000 may be used to finance a house, a car, home appliances and holiday. Prudent consumers (and some small businesses) seeking credit finance may be able to take advantage of such a facility, increasing their flexibility and convenience while minimising total interest payments and transaction costs. Such would be the case where a consumer contained all debt within a single mortgage (assuming the market rate for a first mortgage) rather than have the same amount of principal borrowed from a number of sources (such as first mortgage $60,000, hire purchase $20,000, overdraft $12,000, credit card $8,000). As well, the consumer may have more bargaining leverage with cash. The downside is that ready access to money may encourage some people to take on higher levels of debt than they can realistically manage, especially longer term.

Although industry-wide data is not readily available, industry officials point to fleximortgage products as having increased in popularity recently. Together with the more flexible use of traditional table loans secured by mortgage, these may have restrained growth in both credit card and hire purchase lending.

6.3.2 Banking Ombudsman

A further innovation has been the self-regulatory Banking Ombudsman scheme, which began in July 1992. It arbitrates, in an independent and impartial manner, unresolved disputes concerning all types of banking business normally transacted through bank branches. The scheme is not limited to disputes with consumers. Generally, the scheme is seen as being effective in inducing the prompt resolution of disputes. Effectively, it extends consumers rights without limiting their statutory rights, reducing transaction costs where redress becomes necessary. The service is free to complainants and the Ombudsman has power to award compensation to cover direct losses of up to $100,000, inconvenience up to $1,000, and some costs. The Ombudsman has jurisdiction over bank-issued credit cards, including their use overseas.

6.4 SOME PROBLEM AREAS IN THE CURRENT CONSUMER CREDIT MARKET

The innovations and improvements in types of credit available to consumers have benefited mainly those borrowers who have access to finance from banks and large institutions. Certain groups cannot obtain credit from these sources, usually because they do not own a property to mortgage. The 1996 Census of Population and Dwellings shows that 22.9 percent of private dwellings were rented or leased.^[12]

Despite marginal lenders being seen as the more problematic end of the consumer credit market, far less is known about these institutions than is known about the mainstream ones. Where relevant, the practices of marginal lenders will be investigated over the course of the review.

6.4 cont’d

7. REASONS FOR REGULATION OF CONSUMER CREDIT

5.2 THE ECONOMIC APPROACHES ADOPTED

An efficient market is one in which the output benefits from that market are maximised, at least cost to society. If there are no distortions, a freely competitive market will yield an efficient outcome – but there is no guarantee that it will also achieve social equity. ‘Market failure’ in this context covers all circumstances in which equilibrium in free, unregulated markets may fail to yield an efficient outcome. When this occurs, there is at least some case for government intervention to induce the market to work more efficiently.

The following analysis takes two different economic approaches to the case for public intervention. The first approach uses neo-classical economics for examining market failure and equity issues. The other approach focuses on transaction costs. The two approaches overlap to a considerable extent and, most importantly, there is virtually no disagreement between them in terms of policy conclusions.

This paper briefly summarises the main points of both approaches and presents their overall policy conclusion: that there is a good case for government intervention in consumer credit markets.

7.2 HISTORICAL CONTEXT

It is useful to consider market failure and credit within an historical context. Since World War II consumer credit has experienced sustained growth in most OECD countries, including New Zealand. Growth industries are often characterised by the fluid entry and exit of firms until a competitive equilibrium is reached^[13]. Initially, therefore, unstable conditions combined with the inherent ‘time duration’ aspect of credit transactions^[14] can provide a fertile breeding ground for fraudulent and deceptive practices. In fact, a common perception is that the market for consumer credit is systematically, even irredeemably, flawed – hardly surprising, given the advent of one ‘fast-money’ scheme after another. The reality, however, may be that as credit markets have matured, relative stability has also emerged and the incidence of fraud and deceptive practices has abated.

7.3 MARKET FAILURE AND EQUITY ISSUES

7.3.1 Inadequate Information and Cognitive Error

A common source of market failure stems from an imbalance of knowledge between the lender and the borrower. Disclosure requirements seek to address these informational asymmetries, reducing the ignorance of borrowers and lenders, and so promote efficiency. If meaningful disclosure is inhibited, effective decision making will be impeded.

There is no specific single piece of consumer credit legislation in New Zealand. Instead, as discussed in Chapter 4, there are several Acts providing a regulatory framework for consumer credit transactions up to $250,000. This makes it more difficult for consumers to know and understand their rights and obligations. In particular, it may be a problem for first-time borrowers, or those who borrow only infrequently. Pointedly, the International Adult Literacy Survey found around 45 percent of New Zealand adults were functionally illiterate: approximately 500,000 have minimal or nil reading capability, while a further 750,000 cannot comprehend an everyday document.^[15] The documents on which the survey was based are likely to be less complex than a typical credit contract. The survey also found that the majority of Maori and Pacific Islands people and those from other ethnic minority groups are functioning below the level of literacy required to meet the demands of everyday life. This raises an important equity issue.

Effective disclosure is aided by information being available in a clear, standardised format. The terms of credit contracts, however, are rarely expressed in a standard way but, instead, are often formulated in arcane, technical language; a repeated criticism of the credit market. Standardised, or at least plain English terms would provide a uniform and therefore more intelligible system of communication. A debtor who invested resources to ensure a thorough understanding of the effects of a particular term could re-use the knowledge. For example, if credit providers embodied remedial terms in a standard format, a debtor could compare them (in terms of the risks, etc.) in a more meaningful way. Why, then, has the market failed to produce clear contractual terms? One argument is that credit providers have insufficient incentive to provide clearer terms that are more easily comparable across the available credit alternatives. Because an individual creditor cannot capture the benefits from educating consumers on the functions of particular terms, each creditor has insufficient motivation to encourage consumers to shop around^[16].

The result is that high search costs, non-standard formats and insufficient incentives to provide clearer explanations of the effects of particular terms create information deficits that inhibit effective choice for consumers.

Scott argues that information deficits and high search costs do not necessarily establish market failure: “If the market is competitive, the presence of a sufficient number of ‘shoppers’ should generate optimal terms even though the majority free rides on the efforts

of those who shop. In this case, the conventional argument for regulation must rest on the premise that, in certain cases, systematic cognitive errors impair even the ability of the shoppers to bargain for the terms they prefer”^[17].

7.3.2 Uncertainty

The issue of consumer uncertainty is related to that of information deficits. Making effective decisions requires not only good information, but also reasonable certainty. For many goods and services it is reasonably possible to plan for purchases and budget accordingly. However, there are some circumstances where rational planning is difficult, if not impossible. While a market response to such uncertainty is insurance, for some people insurance is unaffordable – an equity issue. Hence, a life crisis may lead to an urgent need for money and for some people, despite emergency welfare payments and charitable grants, borrowing money urgently without the opportunity to shop around becomes a desperation bid. Such people can become vulnerable, making hasty, poor quality decisions and so falling victim to less reputable lenders.

This is one reason for ‘cooling-off’ periods. There is a strong consensus internationally that an appropriate cooling-off period before concluding the credit transaction gives borrowers a valuable tool to compensate for errors in judgement caused by uncertainty and information deficits.

7.3.3 Moral Hazard and Externalities

What is known as ‘moral hazard’ can apply to both the demand and supply sides of the credit transaction. For borrowers, moral hazard relates to the incentive to over-borrow. If borrowers default, it may not only cause them personal detriment but may also impose a cost on the state (through the social welfare, the justice or the health systems). In this case, there is little incentive for debtors to ‘internalise’ the social costs of default. The state’s backstop role of provider of last resort provides an incentive to over-borrow.

A related argument is that borrowers’ misunderstandings of the consequences of bankruptcy may lead them to be reckless in meeting the terms of credit contracts, or may induce over-borrowing. Some borrowers are under the misconception that bankruptcy will provide a fix-all if they find themselves over-indebted.

Furthermore, the debtor may not fully consider the wider impact of defaulting. For instance, the effects of a repossession may be felt by the borrower’s family, friends and other third parties and may have quite far-reaching spin-offs (for instance, the performance of the borrower’s children at school might be adversely affected). Clearly, externalities of this kind can give rise to significant market failures.

There is also moral hazard on the supply side of the market. The argument here is that some lenders will be prepared to over-lend if they have sufficient ‘economic hostage’ or security in the form of readily marketable consumer durables such as motor vehicles or other property. In these cases, the lender may not have much motivation to assess properly the

borrower’s ability to meet the repayments. The counter-argument, often made by lenders, is that taking ample security reduces commercial risk, and so allows them to offer lower credit charges.

7.3.4 Adverse Selection

Adverse selection might arise in consumer credit markets in various ways. Traditionally, it has been described in relation to the marginal lender segment of the market, where low-income borrowers are concentrated. The reasoning is outlined below.

First, those who are prepared to borrow at a high interest rate generally exhibit an extreme (desperate) position. This implies a relatively high degree of risk. The losses incurred through defaulting debtors need to be covered by the lender, who will be induced to raise interest rates. At a higher interest rate the risk increases, leading to further defaults and thus further losses being incurred by creditors. Theoretically, the market reaches a point where it cannot sustain itself and failure occurs.

Second, a creditor with less onerous remedies (in the event of default) relative to its rivals would be particularly appealing to high-risk borrowers because such borrowers have the most to gain from the more lenient terms^[18]. For example, a cash-loan company that took security up to only the value of the debt would be considered lenient compared with one that took the maximum security possible. The more lenient creditor might, therefore, experience a higher rate of default than its competitors. Unless a higher rate of interest were to compensate for this, the creditor would find the more lenient terms unprofitable, even though consumers preferred such terms. Theoretically, market performance will be impeded as higher risk consumers are charged progressively higher interest rates.

More recently, adverse selection has been described in relation to the credit card industry^[19], in which card issuers apparently have been enjoying a good measure of market power. It is argued that card issuers have wielded market power because consumers (cardholders) are relatively unresponsive to offers of lower interest rates (inelastic demand) and because adverse selection discourages interest rate competition among issuers. The reasoning is that low-risk borrowers belong to a category of cardholders “who do not intend to borrow but find themselves doing so anyway”^[20]. While such borrowers hold positive debt, they are unwilling to search for the best card rate because they consider the debt will be quickly eliminated. Consequently, a card issuer that reduces its interest rate would tend to attract relatively high-risk borrowers; the low-risk borrowers being unresponsive. Potentially, therefore, the issuer would face an adverse selection problem.

7.4 CONSUMER CREDIT FROM A TRANSACTION PERSPECTIVE

Consumer credit transactions have a number of features that differ from the standard consumer transaction:

• the infrequency of consumer credit transactions
• consumers’ lack of information about all features of the law
• the cost of redress for both lenders and borrowers
• lack of choice in the range of financial institutions available to some groups of borrowers
• the complexity of the transaction, which can involve any of the following: a consumer, a seller of goods, a financial institution, and even the state (if redress is involved)
• the transaction occurs through time, with repayment following some time after the initial advance of money.

That consumer credit has these non-standard features does not necessarily make a case for specific government interventions. What it does suggest is that without some interventions transactions of benefit to consumers and to financial institutions may not occur.

7.4.1 The Role of Consumer Credit Law in Reducing Transaction Costs

Sometimes the search for suitable consumer credit is integrated with the purchase of a product (for example, when the seller arranges hire purchase credit as a part of the deal). In many cases, however, the consumer searches independently for the credit. Financial institutions actively advertise and market their services, seeking borrowers and so helping reduce consumers’ search costs.

This advertising and marketing is subject to standard fair trading law. Consumer credit law also places some restrictions upon presentation, notably defining a “finance rate” and the “total cost of credit” with the intention of enabling consumers to compare more easily various offers. Such a law involves compliance costs for firms, but most do not report it as onerous. These interventions parallel those of the Ministry of Consumer Affairs’ Trading Standards Service, which, by standardising weights and measures and ensuring those standards are maintained, reduces the search costs of consumers, at a modest cost to the honest trader.

This type of intervention recognises that consumers are not usually lawyers or actuaries, and so the law reduces consumers’ information and search costs for little additional compliance costs to lenders. Another means of reducing search and other transaction costs is by providing effective programmes of consumer information and education.

Similar considerations apply to cooling-off periods. These may be thought of as a substitute for independent legal advice at the time of the agreement. The cooling-off period also reduces the possibility of oppression. The courts can reopen such contracts and, because the possibility of reopening a contract adds to the uncertainty of the transaction, both parties benefit from the cooling-off period since it reduces the likelihood of court action.

Most loans are repaid with relatively few problems, but some credit transactions do go awry and may involve considerable costs for both the lender and the borrower. This justifies specific consumer law such as the Credit (Repossession) Act, which organises a potentially

chaotic situation and by providing a degree of certainty ultimately reduces transaction costs and the cost of credit.

In summary, transaction-cost analysis suggests that simple, clear consumer credit law requires:

• the use of written contracts
• minimum presentational standards
• standardised disclosure of certain financial details (including the total cost of credit and the finance rate)
• uniform procedures for imposition of penalties and enforcement of securities
• clear provision for penalty interest rates and rebates for early repayment
• reconsideration or cooling-off periods.

7.5 CONCLUSION

Both economic approaches suggest that there are several likely elements of market failure as well as equity concerns in the market for consumer credit. Information-deficit problems may be the most significant. This is particularly so in the cash-loan/marginal lender segment of the market. However, the existence of market failures and/or equity problems, even when proved, offers only a prima facie case for intervention. It needs to be clear that there will be net gains from any proposed intervention.

What other arguments are there for intervening or not intervening in the consumer credit market?

8. CONDUCTING THE REVIEW

8.1 QUALITY OF REGULATION

In reviewing the body of consumer credit legislation and in formulating any proposals for change, the Ministry of Consumer Affairs will use a quality of regulation framework.

8.1.1 Standards for Assessing the Quality of Regulation

The OECD^[21] has identified four sets of quality standards for assessing the quality of regulation. These are:

• user standards – accessibility, clarity, and simplicity
• design standards – consistency and flexibility among rules and in their application
• legal standards – logical structure and clear drafting style
• analytical standards – cost-benefit and cost-effectiveness tests.

From these standards, the Ministry of Consumer Affairs has developed four defining characteristics of good consumer law. It must be accessible, understandable, workable, and enforceable. This means both consumers and creditors:

• must be able to get access to the law in a coherent set of related acts
• must be able to understand their rights and obligations, as far as possible without recourse to professional advisers (plain English drafting is desirable)
• must have strong incentives to comply with the law
• must be able to enforce their rights when things go wrong.

8.1.2 Applying a Quality of Regulation Framework to the Review of Consumer Credit

In conducting any review of consumer credit markets, the Ministry of Consumer Affairs will apply a Quality of Regulation framework. The framework consists of three related documents: the Compliance Cost Statement, the Regulatory Impact Statement, and the Code of Good Regulatory Practice. Together, they provide a robust method for systematically analysing problems and examining selected potential impacts arising from government action. The framework will help give answers to the following questions:

1. What is the nature and magnitude of the problem to be solved? Why has it evolved and what are the incentives for the affected parties?
2. Is there justification for government intervention, or can market solutions solve the problem?
3. Is regulation the best form of government action, or is a mix of regulatory and non-regulatory instruments likely to provide the most cost-effective solutions?
4. Will the benefits of any regulation justify the costs? Will the distribution of regulatory costs and benefits be neutral across all consumer credit markets?

5. Will any proposed regulation be clear, consistent, understandable and accessible to users in the market?
6. Have all interested parties had the opportunity to present their views?
7. How will compliance be achieved? What mix of incentives and institutional arrangements will be required for successful implementation of the proposals?

9. CALL FOR SUBMISSIONS

The Ministry encourages written submissions from interested parties on the content of this document. The purpose of the submissions will be to inform the Ministry as it proceeds with the review consumer credit law. Ultimately, the submissions will inform the government on any decisions it chooses to take with respect to the reform of consumer credit law.

9.1 QUESTIONS FOR SUBMITTERS: A REMINDER

The Ministry is interested in any comments made in response to this document. While it offers the following questions as a general guide, there may well be other matters on which submitters wish to comment.

(1) What other issues related to consumer credit should the Ministry of Consumer Affairs consider in its review?

(2) Is there any merit in distinguishing between mainstream and marginal lenders when considering future legislative proposals? To what extent is it desirable?

(3) Are there any specific problems with the operation of the credit market that are not currently addressed by legislation?

(4) Are the goals of consumer credit law, as formulated by the Ministry of Consumer Affairs, realistic and relevant? If not, why not? Are there any other goals for consumer credit that should be considered? If so, what are they?

(5) Has the Ministry provided an accurate summary of the market for consumer credit and the products available? Is there information available that would fill any gaps in the summary? If so, where can this information be found?

(6) What other arguments are there for intervening or for not intervening in the consumer credit market?

9.2 FINAL DATE FOR SUBMISSIONS AND CONTACT DETAILS

Final date for receipt of submissions: Friday, 24 September 1999

Comments and submissions should be addressed to:

Consumer Credit Law Review Team
Policy Unit
Ministry of Consumer Affairs
PO Box 1473
WELLINGTON

Tel: Rob Bowie 64 4 474-2927
Bob Hillier 64 4 474-2944
Nick McBride 64 4 474-2818

Fax: 64 4 473-9400
Email: rob.bowie@moc.govt.nz

Delivery address:
Level 8
Ministry of Commerce Building
PO Box 1473
33 Bowen Street
WELLINGTON

^[1] Ministry of Consumer Affairs, Wellington, 1988

^[2] See for instance: McLauchlan D. “Contract and Commercial Law in New Zealand” (1984) 11 New Zealand Universities Law Review, 36-65; Consumers’ Institute, The Reform of Consumer Credit Law, Wellington: Consumers Institute, August 1998; Baird S. “Consumer Credit Reform” [1999] New Zealand Law Journal 95-96

^[3] The policy distinctions between consumer and commercial credit will be examined later in the review, in the context of the correct application of consumer credit legislation.
^[4] Borrowdale A. et al, Butterworths Commercial Law in New Zealand (3rd ed.), Wellington: Butterworths, 1996
^[5] For a review of the Property Law Act, see Law Commission, A New Property Law Act, NZLC R29, 1994

^[6] Lanyon E. “Cassandra’s Curse: Disclosure Under the Australian Consumer Credit Code” [1997] 5 (6) Consumer Law Journal, 178-191

^[7] As Farrar states, “the financier may express the credit charge rate as a flat rate, simple rate, reducible rate, compound rate, add-on rate, nominal rate or effective rate; moreover the rate may be expressed on an annual, monthly or other periodic basis.” See Farrar J. Butterworths Commercial Law in New Zealand, Wellington: Butterworths, 1985, 252

^[8] See Reserve Bank of New Zealand, Financial Statistics Vol 2 No 1, March 1999, 21-48; see also Bowie R. “Perspectives on consumer credit” (1998) 10 Compliance, 4-7

^[9] The Reserve Bank estimates that 95 percent of the total value of all household institutional borrowing (including hire purchase) is captured within the Household Claims Series. It also estimates that over 90 percent by value of an aggregate household loan market exceeding $60billion (excluding student loans) is loaned by the ten largest institutions surveyed.
^[10] Statistics New Zealand, New Zealand Official Yearbook 1998, Wellington: Statistics New Zealand, 1998, Ch 27
^[11] Reserve Bank of New Zealand, op cit
^[12] Statistics New Zealand, 1996 Census of Population and Dwellings, Wellington: Statistics New Zealand, 1997
^[13] See Scott R. “Rethinking the Regulation of Coercive Creditor Remedies”, (1989) 89 Columbia Law Review, 730-788

^[14] That is, credit (loans) often extended for lengthy periods of time – in the case of a mortgage, up to twenty years or

longer.

^[15] Adult Literacy in New Zealand: Results from the International Adult Literacy Survey, Ministry of Education (Undated – survey conducted March 1996)
^[16] Scott R. op cit
^[17] Ibid

^[18] Federal Trade Commission Credit Practices Rule: Statement of Basis and Purpose and Regulatory Analysis (1984) 49 Federal Regulation 7740, 7780

^[19] See Ausubel L. “The Failure of Competition in the Credit Card Market.” (1991) 81 (1) American Economic Review, 50-81; and Calem P. and Mester L. “Consumer Behaviour and Stickiness of Interest Rates” (1995) 85 (4) American Economic Review, 1327-1336
^[20] Ausubel L. op cit

^[21] See Recommendation of the Council of the OECD on Improving the Quality of Government Regulation, Adopted 9 March 1995