New Zealand Ad Hoc Government Discussion Papers
Last Updated: 18 April 2020
CONSUMER CREDIT LAW REVIEW
PART 1 SETTING THE
Level 8, Ministry of Commerce Building
PO Box 1473, Wellington
Tel: 04 474 2750
Fax 04 473 9400
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, 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. This criticism is based on various considerations, including:
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:
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
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
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
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.
Consumer credit is defined generally as being credit provided under a
contract to a natural person who uses it, or intends to use
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
provided by a lender in the ordinary course of, or incidental to, the
business carried on by that lender. We are not concerned with
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:
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.
means of dealing with consumer credit, such as reliance on the
common law or on more general, business-oriented credit statutes,
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
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. 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
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
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
(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
4.5 DOOR TO DOOR SALES ACT 1967
act establishes specific disclosure rules, and provides a seven-day cooling off
period, for credit contracts that are made via
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
4.7 RECENT CHANGES TO CREDIT LAW
Reforms that have been passed recently are:
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
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:
If this argument is tenable, then an assessment of the relative
costs/consequences of easing the regulatory regime for the mainstream
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
level of questionable practice and consumer detriment within this segment of
the market. If problems concerning bad business practice/unethical
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
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
the broadest sense, the Ministry submits that consumer credit law should seek to
achieve the following goals:
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
which will allow consumers to bargain and transact freely with
5.2 REQUIRE EFFECTIVE INFORMATION DISCLOSURE, SO THAT:
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:
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
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
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
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. 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
it must be appropriate, well designed and enforceable in order to achieve
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,
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
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
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
of redress for those cases where loan repayments do not take place as
contracted, and other costly measures, including debt write-off.
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
transactions in the spectrum. The vertical axis reflects the
APR for each transaction.
Fig .1 CONSUMER CREDIT MARKETS AND THE COST OF CREDIT
←Market A→ ←Market B→
←Market C→ ←Market D→
Consumer Credit Transactions
Figure 1 above suggests that the overall market can be simplified into four separate market segments:
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. This Series includes the major retail banks and various other sizeable household lenders; in total, about 25 institutions. 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
number as most of the larger ones became banks, while some banks which owned separate finance companies incorporated these operations within the bank itself.
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.
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
a property to mortgage. The 1996 Census of Population and Dwellings
shows that 22.9 percent of private dwellings were rented or
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.
Is this an accurate summary of the market and the products available there?
Is there information available that would fill any gaps in this summary? If so, where can this information be found?
7. REASONS FOR REGULATION OF CONSUMER CREDIT
5.2 THE ECONOMIC APPROACHES ADOPTED
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,
may fail to yield an efficient outcome. When this occurs,
there is at least some case for government intervention to induce the
work more efficiently.
The following analysis takes two different economic approaches to the case
for public intervention. The first approach uses neo-classical
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
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. Initially, therefore, unstable conditions combined with the inherent ‘time duration’ aspect of credit transactions 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. 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
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.
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
impair even the ability of the shoppers to bargain for the terms they
The issue of consumer uncertainty is related to that of information deficits.
Making effective decisions requires not only good information,
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
This is one reason for ‘cooling-off’ periods. There is a strong
consensus internationally that an appropriate cooling-off
concluding the credit transaction gives borrowers a valuable tool to compensate
for errors in judgement caused by uncertainty
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
for debtors to ‘internalise’ the social costs of default.
The state’s backstop role of provider of last resort
provides an incentive
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. 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, 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”. 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
transactions have a number of features that differ from the standard consumer
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
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’
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:
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
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 has identified four sets of quality standards for assessing the quality of regulation. These are:
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:
8.1.2 Applying a Quality of Regulation Framework to the Review of Consumer
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:
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
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
Ministry of Consumer Affairs
PO Box 1473
Tel: Rob Bowie 64 4 474-2927
Bob Hillier 64 4 474-2944
Nick McBride 64 4 474-2818
Fax: 64 4 473-9400
Ministry of Commerce Building
PO Box 1473
33 Bowen Street
OFFICIAL INFORMATION ACT 1982
In providing your submission, please advise us if you have any objections to the release of your submission, the parts of your submission that you would wish withheld if you do object, and the grounds for withholding. The Ministry will carefully review any representations that you make in this regard, in preparing and releasing any summary, and in considering any formal Official Information Act requests that might be received in the future.
PRIVACY ACT 1993
Any personal information that you supply to the Ministry in the course of making a submission will be used only by the Ministry in conjunction with consideration of matters covered by this discussion paper only.
When preparing any summary, for public circulation, of submissions on Ministry discussion papers, it is the Ministry’s normal practice to set out the names of parties making submissions. Your name will be included in any such summary unless you inform the Ministry that you do not wish your name to be included. In order to indicate your wishes, or to view personal information held about you in respect of the matters covered by this discussion paper, or to request correction of that information, please contact the Ministry of Consumer Affairs, ph (04) 474 2750.
 Ministry of Consumer Affairs, Wellington, 1988
 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”  New Zealand Law Journal 95-96
 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
 Borrowdale A. et al, Butterworths Commercial Law in New Zealand (3rd ed.), Wellington: Butterworths, 1996
 For a review of the Property Law Act, see Law Commission, A New Property Law Act, NZLC R29, 1994
 Lanyon E. “Cassandra’s Curse: Disclosure Under the Australian Consumer Credit Code”  5 (6) Consumer Law Journal, 178-191
 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
 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
 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
exceeding $60billion (excluding student loans) is loaned by the ten
 Statistics New Zealand, New Zealand Official Yearbook 1998, Wellington: Statistics New Zealand, 1998, Ch 27
 Reserve Bank of New Zealand, op cit
 Statistics New Zealand, 1996 Census of Population and Dwellings, Wellington: Statistics New Zealand, 1997
 See Scott R. “Rethinking the Regulation of Coercive Creditor Remedies”, (1989) 89 Columbia Law Review, 730-788
 That is, credit (loans) often extended for lengthy periods of time – in the case of a mortgage, up to twenty years or
 Adult Literacy in New
Zealand: Results from the International Adult Literacy Survey, Ministry of
Education (Undated – survey conducted March
 Scott R. op cit
 Federal Trade Commission Credit Practices Rule: Statement of Basis and Purpose and Regulatory Analysis (1984) 49 Federal Regulation 7740, 7780
 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,
 Ausubel L. op cit
 See Recommendation of the Council of the OECD on Improving the Quality of Government Regulation, Adopted 9 March 1995