The Office of Fair Trading (OFT) has given the top 50 payday loan companies 12 weeks to change their business practices or risk losing their licences.
After a review into the controversial short-term loans industry, where APRs can be as high as 4,000%, the OFT said it had uncovered evidence of "widespread irresponsible lending" and a failure to comply to required standards.
Today, it announced the leading 50 lenders, which account for 90% of the market, have three months to change their ways. It also floated the idea of referring the payday loans market to the Competition Commission after it found evidence of "deep-rooted problems in how lenders compete with each other".
The review into the £2 billion industry found a host of problems, including aggressive debt collection practices, a failure to explain how payments will be collected and lenders failing to conduct adequate assessments of the borrower before lending.
A report by the OFT stated: "Too many people are granted loans they cannot afford to repay and it would appear that payday lenders' revenues are heavily reliant on those customers who fail to repay their original loan in full on time."
New statistics from the Financial Ombudsman Service (FOS), which handles the industry's complaints, show it is currently finding in the consumer's favour in nearly three quarters of cases involving payday lenders.
Clive Maxwell, chief executive of OFT, said: "We have found fundamental problems with the way the payday market works and widespread breaches of the law and regulations, causing misery and hardship for many borrowers.
"Payday lenders are earning up to half their revenue not from one-off loans, but from rolled over or re-financed deals where unexpected costs can rapidly mount up."
He added: "Irresponsible lending is not confined to a few rogue payday lenders - it is a problem across the sector. If we do not see rapid, significant improvements by the 50 lenders we inspected they risk their licences being removed."
David Rodger, chief executive of national debt advice charity Debt Advice Foundation, added: "Our experience is many people take out more and more payday loans in a desperate attempt to stave off debt – a downward spiral which can only ever make their position far worse. So the approach of this report is to be welcomed."
Joanna Elson, chief executive of the Money Advice Trust, welcomed the report and called for an on-going, close monitoring of the industry.
The OFT is running a consultation on payday lenders until 1 May, with a final decision on referring the industry to the Competition Commission expected by June.