Why it's so hard to sell banks on small-dollar lending

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Banks are responding cautiously to the latest federal push to encourage small-dollar loans to consumers with blemished credit, a sign of lingering skepticism about the business opportunities in the subprime market.

While industry officials welcomed the bulletin Wednesday from the Office of the Comptroller of the Currency, which encouraged banks to develop alternatives to payday loans, they made no commitments about their own product roadmaps.

In a statement that was typical of other banks’ responses, a spokeswoman for Regions Financial in Birmingham, Ala., said: “It's clear that consumers have a need for small-dollar loans, and we continue to consider how to best meet the financial needs of our customers and communities.”

The banking industry has been in a similar position before. A decade ago, the Federal Deposit Insurance Corp. developed a pilot program that was meant to show depositories how to profitably offer affordable small-dollar loans to folks who would otherwise turn to high-cost credit.

But the FDIC initiative, which aimed to keep annual percentage rates below 36%, failed to gain much traction, presumably because banks concluded that it would be too difficult to make money on loans at that rate.

The succinct bulletin Wednesday from the OCC does give banks more flexibility than the earlier effort did.

In the document, the OCC does not prescribe any particular pricing scheme, though the agency says that loans should support borrower affordability, and it indicates a preference for loans that borrowers will pay off in equal installments over a period of two to 12 months.

But even assuming that banks can now offer loans with APRs above 36% without incurring the wrath of the OCC, they may hesitate to enter the market because of the reputational damage they could sustain due to opposition from consumer advocates and congressional Democrats.

“The 36% interest rate cap has a long history going back over 100 years, widespread public support, and increasing acceptance as the dividing line between predatory and mainstream small-dollar loans,” Lauren Saunders, associate director of the National Consumer Law Center, said in a statement. “Higher interest rates encourage misaligned incentives, with lenders profiting while consumers default.”

Not all consumer groups are on board with that message, though. The Pew Charitable Trusts, which has been trying to sell the idea that loan payments should be no more than 5% of a borrower’s monthly income, responded favorably to the OCC’s announcement.

Nick Bourke, who directs Pew’s work on consumer finance, argued that there is an opportunity for banks to make a profit on installment loans with APRs below 100%, while also offering savings to borrowers who would otherwise seek credit from higher-cost providers.

“So prices may be a little higher than credit cards, but they’re going to be a lot lower than payday lenders,” he said.

The premise that banks can earn profits on unsecured subprime loans while maintaining their affordability may rest on the assumption that the loans will be underwritten in an automated fashion.

The OCC said that banks should turn to both external and internal data sources, including deposit activity, to assess applicants’ creditworthiness and to effectively manage credit risk.

The agency’s message suggests that — to the extent there is an opportunity here for banks — it will be with their existing customers rather than with new prospects. Banks have a deep understanding of the cash flow of their checking account customers, and they already use that information to make automated decisions about when to approve overdrafts.

In addition, customers who use more than one product from a bank are more likely to generate profits than customers whose relationships are more limited.

Regions and Fifth Third Bancorp in Cincinnati are among a small number of banks currently offering small-dollar credit to subprime consumers.

Regions offers savings-secured loans and lines of credit and a savings-secured credit card to existing customers. Fifth Third’s line of credit is only available to customers who have had an account with the bank for at least a year, a limitation that yields insight into borrowers’ earning and spending patterns.

If banks were to offer these loans to new customers, they would be costlier to underwrite, which would make it harder to record a profit. “To lend someone $3,000, manual underwriting would completely turn the business proposition upside-down,” said Donald Lampe, a lawyer at Morrison & Foerster.

Even with the flexibility granted by the OCC, banks may hesitate to offer small-dollar loans for fear of cutting into the revenue they generate from overdraft fees, said Saunders, of the National Consumer Law Center. Banks earn roughly $11 billion a year in fees from consumer overdrafts, according to FDIC data.

“I don’t think we are going to see mass adoption of affordable small dollar loans in the bank space until they get off the abusive overdraft gravy train,” Saunders said.

Some 24.5 million U.S. households were classified as underbanked in 2015, meaning that they had bank accounts but also had turned to a payday lender or another alternative provider of financial services within the previous year. Many of these folks had volatile incomes and took out high-cost loans in order to make ends meet.

One important question now is whether the Federal Reserve Board and the Federal Deposit Insurance Corp. will endorse the OCC’s position. A majority of the 5,600 or so banks in the U.S. are not regulated by the OCC.

Large banks that are regulated by the agency include JPMorgan Chase and Citigroup, both of which declined to comment on the OCC’s action.

Wells Fargo and U.S. Bancorp are both OCC-regulated banks that stopped offering short-term, high-cost consumer loans in response to a crackdown by the agency in 2013. That guidance was rescinded last year, in what was interpreted as a signal to banks that the Obama administration’s concern about high interest rates no longer applies.

Both Wells and U.S. Bank issued statements Wednesday that pledged to help customers meet their financial needs, but sidestepped comment on the OCC’s new framework.

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Small-dollar lending Subprime lending Payday lending Financial regulations OCC Wells Fargo Regions Bank Fifth Third U.S. Bank FDIC