Current bank-fintech partnerships are a classic example of regulatory arbitrage.
By originating loans on behalf of fintech lenders, which handle all other aspects of the lending process, banks allow their fintech partners to bypass state licensing requirements and interest rate restrictions.
If you think regulatory arbitrage is bad, as most people do, then you are probably in favor of new rules to restrict these so-called rent-a-charter schemes. But not everyone agrees that regulatory arbitrage is inherently flawed. Some scholars have characterized regulatory arbitrage as an economically efficient process that drives transaction costs down.
But this view ignores the purpose of the regulation in question, which is presumably to avoid a bad outcome.
Critics of rent-a-charter schemes argue that the regulations being arbitraged are designed to protect consumers from predacious interest rates. Their view is shared by President Biden, who said during a 2021 signing ceremony repealing the Office of the Comptroller of the Currency's "true lender" rule: "In many states, these lenders are kept in check by caps on how much interest they can charge, but some loan sharks and online lenders have figured out how to get around these limits ... by using a partnership with a bank to avoid the state cap and charging outrageous interest ... ."
Of course, the level of interest that counts as usurious is subjective, since usury rates vary state to state.
Therefore, an assessment of bank-fintech partnerships should be premised on more detailed analysis than whether a loan made under such a partnership would have been illegal had it been made by a fintech.
If the majority of fintech loans result in the borrower becoming stuck in a cycle of debt, then clearly new rules are needed. But, there is not sufficient evidence to suggest this is the case. We simply need more time and data to determine if fintech lending expands access to credit to populations that historically did not have access to affordable, or any, credit and at what cost.
We will soon know more about the impact of fintech lending and the efficacy of the rent-a-charter model. Fintech lending came into being in the wake of the financial crisis and rode a decade plus of economic growth and stock market gains. Now that the business cycle has turned, some fintech lenders may realize that their proprietary underwriting algorithm isn't as good as they thought. If this happens, fintech lenders may experience a wave of customer defaults and suffer large losses.
Another risk facing fintech lenders is the potential for investors to stop buying their loans. If that happened, most fintech lending platforms would be forced to shut down or at least severely restrict new lending. Now that the Federal Reserve is raising rates, fintech lenders may be forced to charge borrowers more so they can keep selling loans to yield-conscious institutional investors. But if borrowers can obtain lower rates elsewhere — at a bank, for instance — they may no longer be willing to borrow from fintech lenders.
If fintech lenders come under stress, so too will their bank partners. A select few mid-sized banks have made fintech loan origination a key component of their business model. In what can aptly be described as "double regulatory arbitrage," several of these banks are Utah-chartered industrial loan companies. ILCs have virtually all the same powers and privileges as insured commercial banks.
The key difference between ILCs and commercial banks is that ILCs operate under a special exemption to the Federal Bank Holding Company Act, which means they are not subject to the same Federal Reserve prudential supervision as applies to bank holding companies and are therefore not required to maintain the separation of banking and commerce, which Congress has historically mandated for bank holding companies.
One indirect method to address concerns around rent-a-charter would be to close the ILC loophole that permits commercial ownership of FDIC-insured banks.
That would result in ILC parent companies being subject to consolidated Federal Reserve supervision. This would allow the Fed to conduct a fresh review of bank-fintech partnerships to ensure they do not pose a material financial or reputational risk to the parent company of the originating bank.
Of course, closing the ILC loophole does nothing to stop state- and federally chartered banks from originating loans for fintech lenders. At a bare minimum, federal banking agencies should ramp up their enforcement of existing guidance on third-party relationships, which is designed to regulate activities that are conducted by bank partners as if they were being conducted by the bank itself. This will help curb the worst kinds of abuse.
But regulators and Congress would be wise to wait until the current economic downturn recedes and additional data on the performance of fintech lenders is available before taking further steps aimed at restricting bank-fintech partnerships.
