The financial regulator is calling for a government review of credit union rules to give vulnerable consumers a viable alternative to payday lenders.

The Financial Conduct Authority said looser laws would allow credit unions to offer a wider range of products and services to customers. It said the move could help higher risk customers who often turn to expensive payday loans to make ends meet.

More than 400 credit unions operate in the UK. The non-profit cooperatives are controlled by their 2 million members and traditionally specialise in loans and savings for the less well-off. They usually serve members who work or live locally and offer loans that start as low as £50. That is compared with commercial banks, who tend to offer loans no smaller than £2,000 and often reject high-risk customers.

Banks accused of abandoning England's poorest communities Read more

The FCA says the network could be a safer alternative for customers who fail to qualify for loans from mainstream lenders but need credit to pay for essential household goods. It is now up to the Treasury to launch a review of the legal restrictions on credit unions, the FCA said.

“In the short-term at least, the capacity of credit unions to make credit available to a significant portion of high-cost credit users is limited,” the FCA said.

“We believe that, in the longer term, to facilitate the growth of larger credit unions, HM Treasury should consider if there is value in a review of credit union and society legislation.”

The recommendations were made in a 49-page report on alternatives to high-cost credit, published nearly a year after the collapse of the payday lender Wonga. The business was brought to its knees last August following a spike in complaints on historic loans that featured interests as high as 5,000%.

The FCA took over the regulation of payday lenders in 2014 and capped their loan charges a year later. It means lenders can no longer charge more in fees and interest than the amount borrowed.

Credit unions can charge a maximum annual percentage interest rate (APR) of about 42.6% in the UK, except in Northern Ireland where the maximum is 12.7%. New sources of growth could support smaller credit unions, nine of which went bust last year. They included K&C Credit Union, based in the Borough of Kensington and Chelsea in London. It is believed bad debts were to blame for its demise.

Sign up to the daily Business Today email or follow Guardian Business on Twitter at @BusinessDesk

The Association of British Credit Unions Limited, which represents 187 credit unions, was enthusiastic about the FCA’s recommendations. “Credit unions – by a margin of hundreds of millions of pounds – are the most active and sustainable providers of affordable credit to those underserved by the mainstream and who borrow from expensive alternatives. Our work suggests that liberalising the Credit Unions Act to broaden our powers would allow credit unions to expand and play a bigger role in disrupting high-cost credit.”

However, the debt charity StepChange said more radical solutions should be explored, such as zero-interest loans, designed to help people trapped in problem debt. No-interest loans “would help to address the gaping holes in some household finances, which are currently met by high-cost credit,” said Peter Tutton, the head of Policy at StepChange.

A Treasury spokesman said it is already spending £2m “to help credit unions innovate”.