The U.S. Department of the Treasury issued a white paper entitled “Opportunities and Challenges in Online Marketplace Lending” on May 10, 2016. The white paper includes a broad survey of the current state of the market, a review of comments submitted by lenders, consumer advocates and others in response to a 2015 request for information (RFI), and several new recommendations proposed by Treasury itself. This client alert briefly summarizes the white paper’s presentation of the comments received and Treasury’s policy proposals.
Treasury’s Summary of Comments
According to the white paper, comments responding to the Treasury’s earlier RFI revealed several common themes.
New Data and Modeling Techniques Are an Innovation and a Risk. The increasing use of, and reliance upon, new digital data sources, “big data” and the automation of the credit-decision process through the use of algorithms reduces costs to borrowers, decreases turnaround times, reduces fraud and potentially enhances creditworthiness assessments. However, such techniques, and the opaque modeling methods on which they rely, pose the following risks:
- Credit applicants who wish to challenge inaccuracies in their credit file may have insufficient recourse;
- Lenders do not report inaccuracies to credit bureaus because their data gathering techniques downplay the role of such bureaus;
- Correlations uncovered in evaluating data can inadvertently lead to credit extension policies that have a disparate impact or constitute fair lending violations;
- Credit applicants lacking a large digital footprint may in effect be penalized;
- Vulnerable borrower segments may be susceptible to predatory lending; and
- The use of borrowers’ social media accounts in underwriting may be contrary to consumer expectations.
Expanding Access to Credit. Online marketplace lending has expanded access to credit for segments that may be less able to obtain credit from traditional financial institutions. The expansion of credit availability varies by type of borrower and loan.
Most consumers obtain marketplace loans in order to consolidate debt from credit cards or student loans, and most of these consumers have prime or near-prime credit. Nevertheless, lenders are increasingly identifying and making loans to sub-prime borrowers who demonstrate the potential to improve their credit in the near future.
Online lending to consumers seeking to obtain or refinance student loans targets borrowers with high FICO scores, established work and repayment histories and much higher-than-average income. This allows online lenders to offer rates that are lower than those offered by the federal student loan program (which does not price interest rates based on borrower risk and offers relatively favorable repayment and loan forgiveness terms).
Marketplace lending is expanding access to relatively small, short-term loans for small businesses that find it difficult to obtain affordable credit from traditional financial institutions. Target customers for small business marketplace lenders include:
- Small businesses with good credit seeking immediate capital;
- Small businesses unable to receive loans from community banks due to the costs associated with making small loans;
- Small business owners with positive cash flows but low personal FICO scores; and
- Online businesses lacking hard assets that could serve as collateral.
Distribution partnerships (between marketplace lenders and traditional financial institutions) are proving particularly useful in making credit available online. Such partnerships provide a source of referrals of borrowers who are not well served by traditional lenders; reduce acquisition costs; and may reduce the cost of providing products that are less commoditized than those typically offered to consumers. Traditional lenders must, however, develop methods for ensuring compliance with prudential and legal requirements.
New Models Are Untested. Commenters noted that the new underwriting models and underlying operations have not yet been tested through a full credit cycle. Many marketplace lenders outsource some core functions, in contrast with traditional depository institutions. Given industry reliance on a relatively small number of outsourcing firms, this potentially raises concerns in the event such service providers themselves experience difficulty. For this reason, many investors in marketplace loans insist on back-up servicing arrangements.
Uneven Regulatory Regime.
- While consumers expect consumer protection laws to be uniform across different types of lenders, that is not the case in practice and marketplace lenders may be treated differently from traditional financial institutions. It may not be possible to effectively enforce consumer protection laws and regulations against marketplace lenders who are not subject to federal supervisory authority.
- Given the small size and limited sophistication of some small businesses, they should, according to some commenters, enjoy the same protections as do consumers who take out consumer loans; there should be greater protection of small business data privacy; and there should be standardized disclosure of the cost of credit to small business borrowers.
Transparency. A wide range of commenters argued for greater transparency for borrowers and investors, such as:
- Standardized and clear terms and greater disclosure to borrowers;
- Consistent disclosure for investors; and
- The establishment of a centralized registry to track both loan-level data and transactions.
Undeveloped Secondary Market. Some commenters argued that the secondary market in marketplace loans is insufficiently developed and that the further development of such a market would allow a more accurate marking-to-market of loan portfolios and reduce funding risks and funding and borrowing costs.
Those commenters see the following factors as impediments to the growth of such a market:
- Smaller loan size;
- Underdeveloped trade and portfolio management infrastructure;
- Uncertainty over whether the National Bank Act will continue to preempt state-law usury claims against third-party assignees of loans assigned to them by a national bank;
- Limited ratings from credit rating agencies;
- Lack of information regarding underlying collateral; and
- Lack of disclosure to investors regarding small business loans.
Lack of Regulatory Clarity. Regarding the current lack of regulatory clarity, commenters took varying positions with regard to a number of issues, such as the proper role for federal regulation, the disparate treatment of consumers and small businesses, the proper organizational structure of federal regulation, the need for better online security, the attribution of lender status in various types of marketplace lending structures, the increased uncertainty as to responsibility for anti-money laundering compliance, and the need (or lack thereof) for risk retention requirements in various business models similar to those imposed upon asset-backed securities in securitizations.
In response to the comments received and as a result of its own investigations, Treasury makes a number of recommendations in the white paper.
More Small Business Borrower Protections. Treasury calls for more protections for small business owners and more oversight for lenders to small business. Treasury notes that:
- Small business borrowers are dissatisfied with the high interest rates, unfavorable repayment terms and lack of transparency in marketplace loans;
- Although marketplace lenders originating small business loans may be subject to the same statutory requirements as depository institutions, marketplace lenders originating small business loans are not subject to the same degree of oversight by prudential regulators;
- Small business loans under $100,000 share many common characteristics with consumer loans; and
- A coalition of lenders themselves has proposed the “Small Business Borrowers’ Bill of Rights,” including rights to transparent pricing and terms, non-abusive products, responsible underwriting, fair treatment from brokers, inclusive credit access and fair collection practices.
Enhance Servicing Infrastructure and Back-End Operations. Because the current credit climate is relatively favorable, Treasury raises the concern that existing servicing and collection arrangements will not be sufficient once delinquencies increase. As a consequence, Treasury recommends that market participants should:
- Develop contractual or other mechanisms to align the interests of borrowers and investors;
- Provide strong, consistent and efficient customer service from origination to repayment, even for delinquent borrowers;
- Provide (and ensure that third-party servicers provide) accurate and actionable information to borrowers, possibly including Fair Debt Collection Practices Act guidelines, dispute resolution options and credit counseling; and
- Develop comprehensive arrangements to ensure loans continue to be serviced and collected if the lender ceases operations.
Treasury additionally encourages depository institutions, including Community Development Financial Institutions (CDFIs), to assist marketplace lenders in adhering to industry standards and identifying back-up servicing options.
Enhance Transparency. Treasury further recommends that the industry should:
- Adopt standardized representations, warranties and enforcement mechanisms;
- Establish consistent reporting standards for loan origination data and ongoing portfolio performance;
- Make data available on loan securitization performance;
- Adopt consistent market-driven pricing methodology standards;
- Liaise with consumer advocates to ensure strict privacy and adherence to data security standards; and
- Create a private-sector-driven, publicly available registry for tracking data on transactions, including note issuances, securitizations and loan-level performance.
Expand Access to Safe and Affordable Credit through Partnerships with CDFIs. Treasury notes that marketplace lenders primarily serve prime and near-prime borrowers. Treasury encourages marketplace lenders to develop partnerships with CDFIs in order to enable CDFIs to share their expertise serving borrowers living in distressed areas or lacking an extensive credit file with marketplace lenders. In exchange, CDFIs should increase their own efficiencies and lower costs by using marketplace lenders’ underwriting technology and back-end operations.
Increase Access to Data. Treasury urges federal agencies to:
- Adopt guidelines and standards that would enable and encourage third-party companies and nonprofits to create loan comparison shopping sites for borrowers; and
- Automate data services used by lenders to verify a borrower’s income and assets when making lending decisions.
Creation of Interagency Working Group. Treasury also recommends the creation of an interagency working group consisting of Treasury, CFPB, FDIC, FRB, FTC, OCC, SBA, SEC and a representative of a state banking supervisor. The group would be tasked with identifying areas where additional regulatory clarity could protect borrowers and investors and expand access to credit. Treasury proposes that the group could:
- Identify and educate market participants about the applicability of current regulations, enforcement efforts and potential regulatory gaps;
- Support innovations that expand access to credit;
- Monitor the effects of emerging innovations in credit modeling and suggest technical and regulatory strategies to preserve transparency, fairness, privacy, equity and opportunity; and
- Monitor the evolution of risk through the credit cycle and assist market participants in evaluating the economic impact of untested algorithms.
 In Madden v. Midland Funding LLC, the Second Circuit Court of Appeals held that such state usury law claims would not be so pre-empted. The Supreme Court is currently deciding whether to grant certiorari in the case.
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