The CFPB's Overly Simplistic Approach to Loan Underwriting

The May issue of The Atlantic contains an insightful story titled "The Secret Shame of Middle-Class Americans," by Neal Gabler. Gabler puts a face to one of the biggest economic issues facing this country: the erosion of household savings in America and the resulting traumatic impact on the middle class. He cites a Federal Reserve survey — released about a year ago — finding that nearly 50% of Americans have trouble finding $400 to pay for an emergency and confesses that he finds himself in this same predicament.

By candidly discussing the financial challenges he faces despite being a successful writer, Gabler highlights the fact that bad credit is pervasive. Numerous studies support this. Last year, the Corporation for Enterprise Development reported that a majority of Americans, 56%, had nonprime credit scores, or scores below 700. The Consumer Financial Protection Bureau, meanwhile, recently found that about 11% of the U.S. adult population was "credit invisible," or lacking credit scores.

For most people this isn't due to a lack of education or irresponsible behavior; it's a result of the economic reality that millions of Americans face today. Fluctuations in income and increasing costs of living, especially in health care and education, are causing more and more Americans to live on the edge.

That is why it is so important that the CFPB's upcoming rules on short-term lending not create damaging unintended consequences for the millions of Americans who rely on nonbank credit solutions to help manage financial emergencies.

Much has been written about the proposal's potential to effectively drive short-term payday lenders out of business. Part of why many in the industry view the rules as so onerous is the CFPB's "ability-to-repay" requirement.

On the surface, the CFPB is proposing something that seems sensible — that lenders should be required to assess their customers' ability to repay loans. The CFPB's concern is that improper underwriting of nonprime credit products may harm consumers due to loss of car title or lawsuits against consumers for nonpayment or creation of a cycle of debt.

However, many of the proposed solutions would actually cause consumers more harm. For example, the CFPB may propose exempting certain loans from enhanced underwriting where the monthly payment is no more than 5% of gross income, if they meet other requirements. This is a threshold supported by the Pew Charitable Trusts, and some banks have expressed interest in offering small-dollar credit products that fall under that payment-to-income cutoff.

But gross income is an inappropriate measure since it doesn't account for the borrower's take-home pay or monthly expenses like other debt, housing, food, or other expenses that quickly eat into household cash flows. The simplistic approach suggested by Pew will likely offer too much credit to fiscally irresponsible consumers while unreasonably limiting credit access to more responsible and frugal consumers.

According to industry sources, the CFPB is considering using lender charge-off rates as a metric for determining ability-to-repay effectiveness. A back-end metric of this sort could be useful in identifying lenders that merit increased supervisory scrutiny, but if is used as a simplistic cutoff, it would likely lead to more aggressive collections practices to the detriment of borrowers.

The best way to avoid unintended consequences is to create broad incentives for innovation in underwriting without unduly simplistic regulations. We have entered an era of big data innovation that will likely transform underwriting and lead to significant advances in the process for making lending decisions, especially for nonprime consumers.

Enabled by new machine learning technologies, access to new data sources such as social media and real-time bank account information, financial technology companies are in the process of reinventing nonprime lending with a new breed of products and technology. Why would regulators want to slow the pace of innovation with outdated and overly simplistic credit criteria? The key to implementing successful regulations that don't have unintended consequences is to avoid overly prescriptive rulemaking and instead focus on creating a strong and effective supervisory function.  

I recommend that the CFPB adopt the same sort of language around ability to repay that is found in the Credit CARD Act of 2009. Under that legislation, lenders are required to use "reasonable written policies and procedures to consider the consumer's ability to make the required minimum payments under the terms of the account based on a consumer's income or assets and a consumer's current obligations." This provides flexibility to support ongoing innovation while ensuring a framework for ongoing supervision.

As Gabler's article highlights, nearly half of Americans are now living paycheck to paycheck without significant savings. Without access to credit to help them through financial setbacks, they will face far worse problems than high-cost credit — they may lose their jobs or cars or not be able to pay essential bills. Overly simplistic CFPB rules will likely reduce access to credit and ultimately harm the very Americans the rules are intended to help.

William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting. Isaac and his firm provide services to many clients, including some who may have an interest in the subject matter of this article. The views expressed are his own.