Question

Can you make the case for legalized “loan sharking”? How can usury (the charging of high interest rates) be beneficial no only to the lender but also to the potential borrower?

Use indifference curve analysis to support your argument.

Answer 1

Let us understand first what a loan shark is. A lender that is not authorized by a federal authority to lend money, who is not at all regulated by any regulatory law and lends money for business is known as a loan shark. Loan sharks charge a very high interest rate, substantially higher than an authorized lender such as a bank, but doesn't usually bother too much about paperwork including guarantees, background documents, credit reports, tax payment status, employement status etc.

Loan sharks are often infamous for not only unusually high interest rates but also for harrasment of borrowers for recovery of money. However not everything is seemingly as bad as it seems. Loan sharks cater to a niche market, they borrow money to poor families, to people with bad credit report or to someone who simply needs money 'then and there' due to any exigency. Such customers of theirs can't go to a regulated capital market player for the obvious deficiency of few things such as time, credible background or collateral. These customers usually understand the whole deal they are getting into and the consequences of not repaying on time e.g., additional interest, bullying etc.

Legitimate lenders won't serve this amrket since the risk of default can't be factored into the interest ceiling imposed by the regulatory authority. Ilegal loan sharks don't have such restrictions and can charge interest reflecting actual risk. We should note that borrower is aware of the stringent terms & conditions imposed by loan sharks and hence can be safely assumed to have earnest intention to timely pay back money so that they aren't caught up by laid down conditions. Lenders also seems to be serious about it, they are aware that though borrowers have the intention to timely repay the money but it usually doesn't happen- most of the repayments will fall behind the schedule- and hence the earning opportunity. Federal agencies can think of "legalizing" the whole modus operandi to serve the niche customers by allowing lesser documentation, quick loan disbursal in-lieu of higher interest rates. This approach will have a benefit that customers insulated from illegal parctices of vandalism and threat for loan recovery.

We can use the indifference curve analysis to support our argument listed above. Market will be sensitive to the interest rate and will decline as interest rates grow, however after a certain level, the graph will start flattening indicating that customer is not affected by rate alone but by other factors sucg as time and loan eligiblity.