Can Fair Lending Keep Up with Fintech?

WASHINGTON — As financial regulators consider how to fit the burgeoning marketplace lending industry into the existing regulatory structure, banks and consumer advocacy groups are beginning to question how community reinvestment and anti-redlining statutes might be applied, if at all.

While fintech entrants argue they are democratizing the credit system, some consumer groups are highly skeptical.

"This is all so new," said Ed Mierzwinski, the Consumer Program Director for U.S. Public Research Interest Group. "These new methods, they're designed to avoid existing laws. They are established in ways that they hope to avoid not only the [Community Reinvestment Act], they think they can avoid the [Fair Credit Reporting Act] and the [Equal Credit Opportunity Act] as well. They are looking to bypass the existing regulatory structure."

Regulators are increasingly zeroing in on marketplace lending. The Treasury Department, Office of the Comptroller of the Currency and the Consumer Financial Protection Bureau have signaled moves to take a deeper look at such lenders. San Francisco Fed President John Williams, meanwhile, said in an interview last month that one of his major concerns is the relationship between fintech and fair-lending protections.

That is likely to be a big area of focus. Financial institutions must comply with a bewildering range of such laws, including the Fair Housing Act (1968) and the Equal Credit Opportunity Act (1974), the Consumer Credit Reporting Act (1968) and the Fair Credit Reporting Act (1970).

In general, all loans are subject to these laws regardless of the originating institution, be it a bank, fintech startup or other. So far, many marketplace lenders have opted to meet those compliance burdens by partnering with banks, either by having banks originate the loans, buy the loans that the firms originate, or through some other arrangement.

But bankers fear that some marketplace lenders — if not exactly breaking the rules — are at least bending them.

Todd Baker, managing principal at Broadmoor Consulting, said that because redlining laws, which ban firms from avoiding certain localities based on residents' race or ethnicity, apply to firms that originate loans but not to those that may buy them in the future, it raises questions. The concern is that a bank or marketplace lender could effectively do an end-run around redlining laws by avoiding purchasing loans from certain areas.

"Buyers can redline even if originators can't," Baker said. "That's been an interesting new issue that's been raised: Is that OK? In the marketplace model, originators are only funding the loans that the buyers want, and buyers often don't want loans that they believe are in 'bad' ZIP codes."

Robert Morgan, vice president of emerging technologies at the American Bankers Association, said that one effect of the current regulatory structure is that, while all lenders are subject to consumer protection laws, the fintech firms are less closely supervised.

"If you look at a bank … you have a regulatory process where you have regulators in, proactively looking at whether or not you're complying with these rules and making sure any sort of issues are addressed before there's consumer harm," Morgan said. "That contrasts pretty greatly with these nonbanks where, typically, regulators come in after consumer harm has been done and they've gotten complaints. So it's a little bit of asking permission versus forgiveness."

Diane Standaert, state policy director for the Center for Responsible Lending, said her focus is the extent to which online lenders are using the variance in state usury laws — which limit interest rates on personal loans — to effectively arbitrage high or nonexistent limits and apply them nationwide.

"One of the things that is of interest, and some concern, is the possible revival of the rent-a-bank model, which is where payday lenders sought to export higher rates that aren't allowed under state law," Standaert said.

That issue is already being played out in federal court. The Supreme Court last month asked the solicitor general's office to weigh in on whether it should hear an appeal of a case concerning whether state usury laws apply when a loan is sold across state lines.

Some online lenders — namely Lending Club — have already said they would modify the relationship they have with their primary bank partner, Utah-based WebBank, to sidestep the outcome of the case. But those state usury laws, as well as most of the federal consumer protection laws, don't apply to all kinds of online lending products.

Baker said that some small-dollar loans or lines of credit extended to owners of small businesses are structured in a way that makes them behave more like consumer loans than small-business loans, in which case certain protection for personal property and credit may not apply.

"When you're making a micro-small-business loan, you can rely somewhat on the financials of the business, but you're also looking hard at the FICO score of the principals behind the business, and you're typically getting a personal guarantee," Baker said. "So one of the odd things here is that micro-business loans are often more like consumer loans than they are like small-business loans."

But Jason Oxman, chief executive of the Electronic Transactions Association — which represents fintech firms that provide payment and lending services to small businesses — said that these firms are providing the kind of small-dollar lending services that banks, in many cases, simply won't at an attractive price.

"Banks do a phenomenal job of lending to businesses but banks have such a rigorous regulatory and business regime to follow, that the cost for a bank for underwriting a $100,000 loan is the same as underwriting a $1 million loan," Oxman said. "I think the important consideration is that the flexibility with which new entrants offer services to merchants" be preserved.

Part of that flexibility includes variable terms and conditions for paying back loans — for example, both Square and PayPal allow merchants to dedicate a portion of payments processed with those companies toward repaying an upfront loan — making the timetable of repayment greater or lesser depending on the volume of transactions.

Baker said that model is in some ways comparable to a longstanding business practice of selling receivables — in which a third-party firm buys the promise of a repayment at a discount. Because those kinds of lending arrangements don't have a set termination date, it's hard for regulators to examine exactly how much the borrower is paying in interest.

"Because the maturity of the 'loan' or the time at which the merchant cash advance/receivable sale will be paid off is unknown, you can't calculate an interest rate or APR on the transaction," Baker said. "That's a serious disclosure issue that's been raised."

Another source of concern is the applicability of the Community Reinvestment Act to fintech lenders. The law requires federally insured banks to extend credit, investment and services to low- and middle-income neighborhoods in their "assessment areas." But since fintech firms have no physical presence and are not deposit-taking banks, they are not subject to any CRA requirements.

Public advocacy groups have called on regulators to revise their application of the law to take into account the increasing prevalence of mobile deposits and the decreasing reliance on physical bank branches as a determinant of CRA obligations. Comptroller Thomas Curry said last month that the CRA assessment areas needed to be updated to take those factors into consideration.

Mierzwinski said that to date, neither PIRG nor any other interest group is agitating for CRA application to marketplace lenders. But he said he is concerned that, as marketplace lenders increasingly compete with or partner with banks, the banks may use that competition as a starting point for asking for a legislative rollback of CRA obligations.

"If [banks] are not attacking the Silicon Valley startups … for not having this duty, I would not be surprised if the banks are planning to say to regulators or their representatives in Congress, 'Let's repeal the CRA as it applies to us, or we'll move all our lending to non-CRA-compliant affiliates,' " Mierzwinski said.

Robert Rowe, vice president and associate general counsel in charge of compliance at the ABA, noted that there has been an ongoing debate about the application of CRA rules beyond banks for some time, including for insurance companies and credit unions. As a general matter, he said, firms offering similar products and services should be subject to similar standards.

"One of the things we've always felt is that there should be a level playing field, and if … a company is offering similar products and services, they should be held to the same standard," Rowe said.

To Renaud Laplanche, CEO of Lending Club, that standard has already been met, since marketplace lenders are required to meet the same fair-lending requirements as everyone else. Indeed, Laplanche argued that algorithm-based marketplace lending model may be superior to the traditional model because it limits the potential for human interference and bias.

"I think it is very much a level playing field already," Laplanche said. "I think we probably bring an improvement. It's not a person sitting across a desk from a loan officer and running the risk of any human judgment, bias or prejudice that could exist."

And while the new entrants may not be directly subject to CRA-type requirements, Laplanche said, they have considerable advantages in their ability to reach low- and middle-income neighborhoods because they are accessible anywhere and in many ways more convenient than traditional lenders.

Laplanche pointed to a deal reached between his firm and Citigroup last year that would direct $150 million in loans to borrowers in underserved communities as evidence that fintech may put financial services in reach of the unbanked in ways that traditional banks have not.

"Banks have been using us to reach populations that live in low-income neighborhoods where the bank does not have as much branch network density," Laplanche said.

Robert Lavet, general counsel of SoFi, said that the company is not opposed to increased regulation, particularly if it standardized the relationship between banks and marketplace lenders and between marketplace lenders themselves. But Lavet was skeptical about whether such an arrangement would contemplate low- and middle-income lending rules or obligations.

"We're not averse to regulation if there's some discussion about some kind of legislation establishing minimum criteria for federal licensing for a nonbank consumer lender," Lavet said. "That would be a big positive for us, because it would allow us to standardize more and meet whatever reasonable requirements are put in."

Oxman was similarly upbeat about the potential for a more explicit relationship between marketplace lenders and consumer protection laws to bring clarity to an area that has, to date, been marked with suspicion for all concerned.

"I would say the clouds are parting, not gathering," Oxman said. "What I see … is an encouragement from regulated entities to embrace and deploy new innovative services for the benefit of both merchants and consumers."