Until now, state regulators have mostly failed in their efforts to crack down on unlicensed online payday lenders that often charge borrowers sky-high interest rates.
But New York officials have developed a new strategy that they hope holds more promise: enlisting banks in the fight.
Benjamin Lawsky, New York's superintendent of financial services, told 117 banks this week to take steps to choke off access to the automated payments system that unlicensed online lenders use to debit the checking accounts of consumers.
"Through a cooperative effort with the banking industry, we can work together to stamp out these pernicious, illegal payday loans in New York," Lawsky wrote.
The letter calls on the banks to work with regulators to develop a set of safeguards and procedures to sever the unlicensed lenders' access to the ACH system. Banks that received the letter include Bank of America (BAC), JPMorgan Chase (JPM), Citigroup (NYSE: C), and Wells Fargo (WFC).
New York has one of the strictest usury laws in the country; loans with an annual percentage rate of more than 25% are illegal. But many of the companies that Lawsky is trying to force out of the Empire State are operated by Indian tribes, and they maintain that they are not subject to New York law because of tribal sovereignty.
That has set up a messy legal fight over the reach of state lending laws. "These are transactions that are in fact legal," argues Peter Barden, spokesman for the Online Lenders Alliance, a trade group for companies that make loans without a state license.
Numerous states, including California, Minnesota and Georgia, have recently sent cease-and-desist letters and filed lawsuits in an effort to scare off Internet-based lenders that are operating without state licenses. "The states are getting increasingly interested in these types of lending arrangements from an enforcement perspective," one banking industry source says.
But the states' actions have had limited impact. Eric Wright, a state financial regulator in Maine, told a congressional panel last month: "The powers that we have such as licensing and so on, while we would like to think them to be real, are largely ignored by these companies."
By squeezing the banks as well as the electronic payments network and debt collectors Lawsky is exerting pressure on institutions that conduct much of their business in New York and therefore have stronger incentives to comply with its edicts.
"We're really trying to take a shock-and-awe strategy," Lawsky said in an interview Tuesday. "We want to make payday lending into New York, over the Internet, as unappetizing as possible."
The strategy of targeting banks' role in the payments process mirrors the long-standing efforts of regulators to use banks to crack down on money laundering. And again the banking industry must decide how far to bend to their regulators' will.
JPMorgan, Bank of America and the American Bankers Association all declined to comment on Lawsky's letter. Nacha, the industry group that runs the ACH network, did not respond to a request for comment.
Lawsky clearly believes the banking industry should be doing more than it has done to date. In his letter, he quotes disapprovingly from a recent bulletin issued by Nacha, which states that banks have "no basis" for determining whether a specific transaction "was properly authorized and relates to a bona fide, legal transaction."
Chase announced changes to its policies in March following a New York Times story that showed how the bank benefited financially from the repeated efforts by unlicensed lenders to access its customers' accounts. Under the new policy, Chase charges no more than one fee to customers when the same biller gets rejected multiple times in a 30-day period because the customer's account has insufficient funds.
The unlicensed online lenders maintain that they are in compliance with the federal law that governs electronic transfers. "The consumers who have decided to take out these loans have authorized the use of that process to have funds deposited into their accounts and withdrawn," says Barden of the Online Lenders Alliance.
But consumer advocates say the Internet lenders are taking advantage of loopholes in the law to unfairly squeeze consumers. When their customers miss payments, some lenders will try repeatedly to withdraw the entire amount due from the consumer's bank account. If the account doesn't hold sufficient funds, the customer can get hit with repeated fees.
"I think the banks need to closely monitor the transaction patterns for the companies which they process payments for," says Tom Feltner, the director of financial services at the Consumer Federation of America, adding the frequent triggering of fees for insufficient funds should raise a red flag.
So far the states have been the primary actors in the regulation of online payday lending. But the Consumer Financial Protection Bureau and the Federal Deposit Insurance Corp. are also taking a strong interest in cracking down on unlicensed lenders, according to Lawsky.
"We're coordinating. We're communicating. And we're working with other federal and other state authorities," he says.
Online lenders and their foes would also like to see Congress get involved, though in sharply different ways. The Online Lenders Alliance is pushing for the creation of a federal charter for online lenders, while consumer advocates are supporting a bill that would require the companies to comply with state laws.