Congress has opportunities to address some of the challenges financial technology firms face in the lending sector.
The pace of financial technology innovation in the alternative lending space is nothing short of phenomenal, but it has meant headaches for lenders and vendors waiting for regulation to play catch-up.
Further complicating the issue, some matters involving the fintech sector cannot be addressed by regulatory agencies alone. They require a legislative solution through the U.S. Congress due to statutory issues or other limitations. Thankfully, Congress has taken a strong interest in the fintech industry, and it began work on some of these issues during the final two years of President Obama’s presidency—an effort that has continued under the Trump Administration.
While much of what is happening in Congress feels partisan and politicized, that hasn’t been the case with fintech issues. There have been numerous opportunities for bipartisan solutions.
The Milken Institute launched a fintech program in 2014 that called for new regulatory approaches to deal with innovative tech-savvy companies that operate differently from the traditional banks of old. Milken noted that fintechs were cutting across financial silos and advancing rapidly in areas such as mobile banking, but they were still dealing with a regulatory apparatus built from the depths of the Great Depression.
The Evolving Landscape
The first real regulatory response to the dawning of this new era of fintech came in 2007 and 2008. That’s when the Securities and Exchange Commission (SEC) classified the promissory notes that Prosper and Lending Club offered to the general public as unregistered securities. This action was believed to be the SEC’s entrance into regulating peer-to-peer lenders. From 2010 to 2015, federal regulators also began increasing their attention on fintech companies as the number of businesses operating in the space exploded.
Several other things were occurring around the same time. In 2012, the Consumer Financial Protection Bureau launched Project Catalyst to encourage consumer-friendly innovation in the financial products and services arena. In 2016, the U.S. Department of the Treasury published a white paper called “Opportunities and Challenges in Online Marketplace Lending” to provide an overview of the evolving market. One of the issues the Treasury’s report addressed was the need for regulators to provide additional clarity around the roles and requirements for fintech lending participants.
Also, in 2016, the U.S. Office of the Comptroller of the Currency (OCC) released a white paper detailing the framework to support responsible innovation. The OCC defines responsible innovation as “the use of new or improved financial products, services and processes to meet the evolving needs of consumers, businesses and communities in a manner that is consistent with sound risk management and is aligned with the bank’s overall business strategy.”
The OCC followed up that effort with a white paper covering special purpose national bank charters for fintech firms. More recently, in March 2018, it held an inaugural “listening session” at its Chicago office that involved 30 to 40 people who discussed emerging issues, trends and current events concerning responsible innovation. This included banks and nonbanks talking about partnerships and third-party risk management.
Hitting the Halls of Congress
While regulators have taken actions related to the advances of tech-driven lending, some issues require a legislative solution. Lawmakers, especially those in the House, have held multiple hearings between 2015 and 2017 on fintech-related topics, including mobile payments, peer-to-peer lending, digital currency, blockchain, the JOBS Act and online lending’s role in improving access to small business capital.
From January 2015 to December 2017, the Milken Institute uncovered 71 fintech-related legislative bills. More than half of them received bipartisan support, but it should be noted that it’s been challenging to advance many of these bills. In September 2016, the House passed H.R. 835 promoting a national policy to encourage financial technology innovation, while at the same time protecting consumers’ personal information. Still, such resolutions lack the weight of actual legislation.
Perhaps the most impactful legislation in recent years for alternative lenders has been the JOBS Act, which passed with bipartisan support in 2012 and was signed into law by President Obama. Some provisions took effect immediately, but others required SEC rulemaking. It took the SEC more than three years to pass final rules for the equity crowdfunding provisions under Title III, and those didn’t take effect until May 2016.
Lawmakers in the current 115th Congress have introduced a number of fintech bills, including several that affect the alternative lending space.
Alternative Lending Evolution
The digital lending space has evolved from its peer-to-peer roots with the infusion of institutional investor interest and competition. The space saw significant growth from 2010 to 2015 and has evolved from the days when it saw itself as an alternative to banks in a post-financial crisis where many traditional banks were lending only to the most creditworthy customers. Today, that “us versus them” mentality has faded, and it’s not unusual to see online fintech lending platforms collaborating with traditional banks or with institutional investors.
Under this traditional bank-fintech partnership model, online alternative lenders partner with an issuing depository institution to originate loans. After origination, they buy the loans for sale to investors. The National Bank Act and the Federal Deposit Insurance Act (FDIC) give national banks and state-chartered banks the ability to charge interest rates based on the laws of the state in which the bank, not the customer, is located. But neither Act applies to nonbank platforms, a disadvantage for fintech lenders. Thus the partnerships have been advantageous to this new lending model.
Despite tacit approval from the FDIC and OCC, the Milken Institute notes that this bank partnership model is facing increased litigation risk and objections from consumer advocates and state regulatory authorities. As a result, one of the legislative issues at hand is to address “value when made” (if the loan is nonusurious when made, it remains nonusurious throughout the loan’s lifecycle) and the true lender issue.
Some believe that the partner bank that is originating the loan and selling it to the fintech lending platform under this model is not the “true lender,” given the very small amount of time—which could be as short as a day—the loan remains on the bank’s book. Milken notes that courts have been divided on this issue, leading to uncertainty and lending declines in certain markets where courts have been adverse to the fintech-depository bank partnership model.
According to the Milken Institute: “If a nonbank fintech lender is found to be the ‘true lender,’ they would lose the exportation advantage that fintech lenders currently rely on to market their products and services and could be subject to penalties for violating state usury laws. The uncertainty from recent litigation has resulted in certain platforms changing their models to protect against ‘true lender’ concerns.”
This litigation has threatened the fintech-bank partnership model, which Milken views as approved via updated third-party guidance provided by the FDIC and OCC. Bipartisan legislation has been introduced that would protect this model, where banks and fintechs are able to leverage each others’ strengths to meet the credit needs of their customers while providing a uniform, national market for credit.
The Milken Institute also supports filed legislation on the following issues:
1. Expanded and improved mobile-device banking // Bipartisan legislation has been introduced that addresses the opening of accounts through a mobile device. It would ensure privacy, but allow financial services providers to, with certainty, leverage technological innovations to expand services and maintain relationships with their customers. The legislation would help deal with “banking deserts”—areas with inadequate financial services that make residents vulnerable to predatory lenders that have cropped up since the financial crisis.
2. Enable the reporting of alternative data to expand access to credit // Fintech companies have developed advanced algorithms to determine whether a potential borrower is a good credit risk. Certainly, such algorithms come with risks, such as whether a particular borrower can withstand a broad economic downturn. The Milken Institute recommends a bipartisan legislative effort to encourage the reporting of alternative, positive payment information to the credit bureaus.
3. Develop big data reporting standards // Several bills have been introduced that would require the U.S. Treasury Department to develop common data reporting formats that financial regulators would be required to adopt. Common reporting formats could reduce or remove reporting silos among regulated entities, eliminate duplicative reporting and save time and money for regulators and regulated entities. “Despite the hype regarding big data, it is useless unless the person or organization receiving terabytes of information is able to effectively collect, sort and disseminate it,” Milken notes.
4. Require the IRS to automate certain data collection // IRS Form 4506-T allows a mortgage borrower to request their tax return or have it sent to a third party, such as a lender, but the process can take several days. Automation could make this occur in near real time—speeding up the mortgage underwriting process. Several bipartisan bills have been introduced to address this issue.
Other Issues on the Horizon
There are a host of other fintech issues affecting alternative lenders that Milken didn’t address in its white paper, but they are issues that lenders will want to watch. These issues involve customers’ financial data, regulatory sandboxes, fintech charters and outdated credit scoring models currently used in obtaining a mortgage.
Several of these issues have been quite contentious, including the OCC’s proposal for national fintech charters.
“Lawmakers have also raised concerns with efforts undertaken by certain fintech firms to apply for an industrial loan charter (ILC) from the FDIC. In recent months, SoFi and Square both applied for an ILC, setting off a raucous debate over whether fintechs should even be allowed to apply for an ILC,” the Milken white paper notes.
Many opportunities will exist this year for Congress to address some of the challenges financial technology firms face in the lending sector. The current bipartisan interest in fintech is a positive sign that lawmakers will reach across the aisle with solutions that will provide greater regulatory and legislative certainty and clarity to the nation’s vibrant and still-growing alternative lending sector.
As our world moves more deeply into a digital economy, Congress must take action to keep pace with the speed of innovation with updated and commonsense regulation that offers flexibility for fintech lending platforms and encourages them to continue innovating in the lending sector, while providing robust consumer protections.