Regulatory Road Likely to Get Bumpier for Alternative Lenders
Companies like OnDeck and Lending Club are under pressure to keep finding new borrowers, but there are signs that customer acquisition costs are rising amid heavier competition.May 6
On the eve of Lending Club's successful initial public offering in December, a handful of people involved in alternative lending entrepreneurs, lawyers, and investors met at the law firm Covington & Burling's Washington office to discuss what was next for the industry.
Upon news of Lending Club's opening price of $15 per share one dollar above the anticipated price eyes widened with the same mixture of near-disbelief and excitement that landowners likely experience when discovering a patch of oil on their property.
Soon after the price announcement, Keir Gumbs, the partner at Covington who played host that night, gave some brief remarks about the night's theme: perils that regulatory action can hold for this young sector.
Alternative lending remains minuscule when compared with traditional banking, accounting for an estimated $9 billion in loan volume last year. In order to grow into the $800 billion-plus sector that some boosters predict, the industry will need to maintain the delicate regulatory balance it has so far achieved.
[Coming this November: Marketplace Lending + Investing. Hear how participants in this fast-growth niche are using data and technology to propel lending into the 21st century.]
The question now, which Gumbs sought to address that night, is how do these companies keep growing without screwing everything up?
Over the last few years, federal regulators have largely taken a wait-and-see approach with respect to alternative lending. That has been due to the novelty and small size of the industry, as well as the fact that these lenders appear to be providing tangible benefits to borrowers.
Still, there are practices on both the consumer and small-business sides of the alternative lending business that seem likely to attract more regulatory scrutiny. Among them are tying multiple small business loans to the same collateral, fair lending issues and interest rate disclosures.
Most everyone close to the industry acknowledges that tighter regulation is a risk. "There's not a ton of predictability for companies that are thinking about entering this space or that are already in this space," Gumbs said in an interview shortly after Lending Club's IPO.
So Far, So Good
If April's LendIt Conference at the Marriott Marquis in Times Square were a speakeasy, the phrase "regulatory arbitrage" would have been its password, bandied about by investors and executives alike. The basic idea was that alternative lenders have an advantage by avoiding the regulatory burden that has been foisted onto banks following depressions and recessions.
This kind of talk can set off alarm bells in Washington. But financial policymakers have countervailing reasons to cast a more favorable eye on alternative lenders, a category that includes so-called peer-to-peer, or marketplace lenders, as well as nonbank firms that lend from their own balance sheets.
This is especially true for firms that specialize in small-business lending. Since the recession, policymakers have become increasingly concerned about the difficulty many small businesses have in obtaining credit. Alternative lenders have helped to meet their needs.
Karen Mills, who was administrator of the Small Business Administration from April 2009 to September 2013, is among those concerned about the small-business credit gap. She said it is particularly difficult for small businesses to get loans of less than $150,000. "And we know it's a structural situation," Mills added.
"It costs as much to underwrite a $150,000 loan as it does to write a $1 million loan," Mills explained.
The role that alternative lenders are playing in meeting the credit needs of small businesses has made the industry attractive to politicians. On the campaign trail, job-creating small businesses are as wholesome as apple pie.
During a recent congressional hearing, an industry witness argued that the federal government could be doing more to support P-to-P lending, to which House Small Business Committee Chairman Steve Chabot, R-Ohio, responded: "Well, you've come to the right place for that."
The name of a 2012 law that has eased regulation on marketplace lenders offers another reminder of the political appeal of Main Street businesses. The law is titled the "Jumpstart Our Businesses and Startups Act" literally, the "JOBS Act."
Alternative lenders' ability to meet the needs of many credit-starved small businesses gives them a compelling argument in the halls of power.
"In general I think the best protection for small businesses is to give them access to more sources of capital," former Treasury Secretary Lawrence Summers said in an interview following a speech he gave at LendIt.
Summers sits on Lending Club's board, so he has a financial incentive to support the P-to-P industry. Still, his views about the need to improve small businesses' access to credit likely reflect those of many inside the Obama administration.
Executives at alternative lenders say they have been in contact with the National Economic Council regarding how they use data, in an effort to maintain their positive relationship with Washington.
Bill Phelan, co-founder and president of PayNet, a financial analytics firm that provides data to alternative lenders, has formed an industry advisory group that is meant to present a unified front to the federal government. Phelan said he has met with staff of the National Economic Council, which is part of the White House, and received favorable feedback.
The council referred questions to the Treasury Department. Treasury spokesman Dan Cruz said in an email that the department has followed developments in alternative lending since a 2013 Treasury event where both Lending Club and the small-business lender OnDeck made presentations. He said that the department is seeking to "better understand the potential for online technology to expand access to capital for small businesses."
"More data is needed to fully understand how these lenders and their products compare to traditional banking products for small businesses," Cruz continued. "While online marketplace lending for small business is still relatively new, it does appear to be providing new options for small businesses to access capital."
The CFPB Threat
Ask those associated with alternative finance what their nightmare regulatory scenario is, and a crackdown by the Consumer Financial Protection Bureau comes back as a common answer.
"It's unclear to me for sure whether the CFPB's going to assert jurisdiction and if so how," Covington's Gumbs said in December. "I think that's a huge question mark, and I think that question mark will continue to grow as the industry grows."
"Regulation's going to hit this," predicted Vince Passione, founder and Chief Executive of LendKey, a company that partners with credit unions and small banks to do marketplace lending on a private-label basis.
If tighter regulation does arrive, it is not yet clear what its focus will be. Some observers are worried about a potential crackdown on alternative lenders' so-far successful efforts to avoid state-by-state
lending rules. Others wonder whether alternative lenders will draw more scrutiny as they reach further down the credit spectrum and start charging higher rates.
But so far, the CFPB and other agencies that are focused on borrower protections have not touched alternative lenders with much more than a feather.
Industry officials have been working to keep themselves off the bureau's to-do list of enforcement priorities; behind closed doors, several industry sources made clear that they are keeping the CFPB in the loop about what is happening in alternative lending.
The firms are also selling the idea that they are helping consumers. Lending Club and its top competitor, Prosper Marketplace, acquire customers largely by undercutting the fees and interest rates consumers are paying on their credit cards.
"We're offering more affordable credit" in a way that is "responsible" and "transparent," Lending Club CEO Renaud Laplanche told American Banker at LendIt, hitting the CFPB's buzzwords, knowingly or not.
Marketplace lenders that specialize in student loans also have a positive story to tell in Washington.
For some student loan borrowers, companies such as Social Finance and CommonBond are able to refinance their existing debt at lower rates. So these firms can make the case that they're part of the solution to the pain caused by student debt, which is now approaching $1.2 trillion in the United States.
While the CFPB declined to comment on the marketplace lending industry at large, the CFPB's student loan ombudsman, Rohit Chopra, said in an interview that "increased competition in the student loan market can be a win for consumers in that it can lead to a more transparent process and lower pricing."
At the behest of Chopra, alternative lenders that refinance student loans were invited in January 2014, along with the nation's largest private student lenders and servicers, to meet with CFPB Director Richard Cordray, then-Treasury Under Secretary for Domestic Finance Mary Miller and Education Secretary Arne Duncan.
The industry's business-lending side could also be targeted by regulators, notwithstanding the political popularity of small businesses.
Nonbank companies that lend to small businesses, including OnDeck, largely fall through the regulatory cracks, in part because there is no federal cap on small-business lending rates. Nor do many states cap those rates.
What's more, the federal law that governs disclosures of consumer interest rates does not apply to small businesses. That has led to a situation where certain lenders are refusing to provide an annual interest rate to borrowers, or advertising no prepayment penalties even though the borrower would have to pay interest in order to close out the loan early.
"It is effectively the Wild West in the small-business space," said Brayden McCarthy, head of policy and advocacy at Fundera, which enables small business owners to comparison-shop for loans online, similar to the consumer travel site Kayak.com. McCarthy, who previously served in senior posts at the National Economic Council and the SBA, supports a "small-business borrower bill of rights" for better transparency in the pricing and terms of small business loans.
"It is shocking the number of borrowers that don't realize their personal assets are at stake," he said.
The Federal Trade Commission currently has authority to bring enforcement actions against small-business lenders that engage in unfair or deceptive practices. And while one might not expect the CFPB to have jurisdiction over small business lenders, it does to some extent.
One provision of the Dodd-Frank Act gives the bureau the ability to collect small-business lending data to monitor the firms' adherence to equal lending law.
The rule to implement that enforcement authority has yet to be finalized, but in theory the provision gives the bureau some leeway to take action against perceived bad actors in small business lending.
One area that might attract the CFPB's attention is violations of the Equal Credit Opportunity Act, which forbids discrimination along lines of race, gender and sexual orientation.
Another practice that might get closer scrutiny from regulators is the so-called stacking of loans. This happens when multiple lenders extend credit that's tied to the same collateral. Stacking can happen either because lenders ignore borrowers' earlier debt obligations, or because borrowers deceive lenders when they are applying for a new loan about how large their previous debt obligations are.
"There's a lot of concern about it, and a lot of eyes on it, to make sure that we don't give out too much credit," PayNet's Phelan said, though he added that more data needs to be collected before determining how big a problem stacking is.
Unsurprisingly, the consensus among those in alternative lending is that the industry should self-police in order to forestall greater involvement by regulators.
"I think everyone knows winter is coming," McCarthy said, referring to the regulation of small-business lending specifically. "It's just a matter of time. But the question is: who's going to get out ahead of it, and do what's fair instead of what's easy?"