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UPDATE 2-New U.S. rule on payday loans to hurt industry, help banks -agency

(Recasts with impact of new rule; adds reaction, byline)

WASHINGTON, Oct 5 (Reuters) - Revenues for the $6 billion payday loan industry will shrivel under a new U.S. rule restricting lenders' ability to profit from high-interest, short-term loans, and much of the business could move to small banks, according to the country's consumer financial watchdog.

The Consumer Financial Protection Bureau (CFPB) released a regulation on Thursday requiring lenders to determine if borrowers can repay their debts and capping the number of loans lenders can provide to a borrower. The rule will take full effect in roughly two years.

Mostly low-income earners use what are known as payday loans -- small-dollar advances typically due to be repaid on the borrower's next payday and generally used for emergency and other expenses. Payday lenders generally do not consider traditional credit reports for loan eligibility.

Under the new rule, the industrys revenue will plummet by two-thirds, the CFPB estimated.

The current business model relies on borrowers needing to refinance or roll over existing loans. They pay fees and additional interest along the way that plump lenders' profits, CFPB Director Richard Cordray said on a call with reporters.

Lenders actually prefer customers who will re-borrow repeatedly," he said.

People trapped in a cycle of borrowing to repay outstanding debt can end up paying the equivalent of 300 percent interest, the bureau found in a study it conducted during five years of writing the rule.

The rule will devastate an industry that serves nearly 30 million customers each year, said Ed D'Alessio, executive director of the Financial Service Centers of America, an industry trade group.

"Taking away their access to this line of credit means many more Americans will be left with no choice but to turn to the unregulated loan industry, overseas and elsewhere, while others will simply bounce checks and suffer under the burden of greater debt," he said, adding that it also threatens thousands of jobs at lenders.

Activists and Democrats expect Republican lawmakers, who generally believe CFPB regulations are extreme and onerous, to introduce a resolution to nullify the rule under the Congressional Review Act.

The agency narrowed the final version of the regulation to focus on short-term borrowings, instead of also including longer-term and installment borrowings. It also exempted community banks and credit unions from having to ensure borrowers can repay loans.

Both moves could make it easier for banks to fill gaps left by payday lenders that close shop under the new rule. The Office of the Comptroller of the Currency on Thursday also lifted restrictions blocking banks from making such small loans to aid in that transition. (Reporting by Lisa Lambert; Editing by Richard Chang and Leslie Adler)