To take seriously Comptroller of the Currency Joseph Otting’s recent announcement encouraging banks to offer short-term, small-dollar loans to subprime borrowers as an alternative to payday lenders, one has to believe that he is unaware of both the Community Reinvestment Act of 1977 and the Federal Deposit Insurance Corp.’s small-dollar pilot program from a decade ago.

In an industry based on taking deposits and making various types of loans, it seems absurd that a federal regulator resorts to “encouraging” banks to lend to their own depositors without regard to FICO score — rather than using existing laws and regulations at his disposal.

The CRA mandates that banks serve the credit needs of communities where they source deposits. Although federal regulators enforce this mandate only sporadically and focus almost exclusively on mortgages, the intent of the original legislation is clear, and goes to the essence of banking — taking deposits and making loans — without discrimination.

Joseph Otting, Comptroller of the Currency.
The OCC's Otting wants banks to take on payday lenders in offering small-dollar loans, but his encouragement is unlikely to be sufficient to get them back into the business. Bloomberg News

The FDIC’s two-year pilot program, launched in 2008, was intended “to illustrate how banks can profitably offer affordable small dollar loans as an alternative to high-cost credit products, such as payday loans and fee-based overdraft protection."

Having researched the payday advance industry prior to her confirmation, FDIC Chair Sheila Bair suspected that the effort would be an uphill battle.

“So many banks rely on bounce protection to cover customers’ overdrafts for fees ranging from $17 to $35 per overdraft that they don’t want to cannibalize profits by offering customers other low-cost options,” she said in 2005.

Unsurprisingly, it took the FDIC almost a year to recruit just 31 banks to help the agency identify best practices in affordable small-dollar loan programs that could be replicated by other financial institutions. The banks operated over 550 branches in 27 states.

The banks were encouraged to use the pilot program to “tap into new markets by expanding relationships with individuals who currently may not be fully utilizing the mainstream financial system.”

The FDIC promised that providing small loans in this program would provide the banks favorable consideration in their CRA examinations. Yet just shy of a year into the program, the FDIC capitulated to requests from the banks to increase the definition of small loans to $2,500, up from $1,000. Of 3,140 loans that had already been made, only 1,535 loans were under the original cap.

The agency also reported that most banks had already forsaken profitability as a goal of the initiative. Instead, the banks were using the program to cross-sell checking accounts, through which they could generate more profitable overdraft and nonsufficient-funds fees.

When the program ended in June of 2010, only 28 banks remained. Out of 34,400 loans made in the preceding two years, only 18,163 loans were under the original cap of $1,000. The average loan amount was roughly $700 — twice the size of the average payday loan at the time.

If the OCC really wants to play a constructive role in ensuring more widespread access to credit for all bank customers, instead of pursuing its long-standing vendetta against payday advance companies, there are several concrete steps it could take.

For starters, it could get banks back into basic banking — taking deposits and making a wide variety of loans tailored to the credit needs of their depositors. U.S. banks have a regulatory monopoly on deposit-taking and have almost unlimited lending powers in return for their commitment to serve the financial needs of American consumers. There is no regulatory or legal issue preventing banks from making short-term, small-dollar loans right now. Evidence suggests that banks choose not to make these loans because there are other, more profitable alternatives.

Second, the agency could strictly enforce the original intent of the Community Reinvestment Act, which mandates that banks serve the credit needs of the communities where they source deposits. Not extending credit to an existing depositor — while profiting from overdraft and nonsufficient-funds fees arising from ignoring that depositor’s credit needs — should be as obvious a violation of CRA as it is morally repugnant.

Finally, regulators could stop allowing banks to hide their highly profitable, overdraft lending programs behind the protection of Fed Regulation DD, which implements the Truth in Savings Act, rather than the requirements of Regulation Z, which implements the Truth in Lending Act. This regulatory anomaly enables banks to extend short-term credit through overdrafts without the consumer protection requirements with which all other credit providers must comply.

These requirements are imposed on lenders to ensure that consumers are informed when they incur a debt, know the exact amount of their debt, and understand the cost of their debt expressed as an annual percentage rate.

Last year, U.S. banks received $34.3 billion in overdraft fees without processing loan forms or making disclosures and without monitoring borrowing amounts, borrowing frequency and repayment ability — all of which would be required to provide small loans.

As Bair suggested over a decade ago, this "easy money" is a powerful disincentive for banks to resume making short-term, small-dollar loans that comply with requirements imposed on all other lenders.

For Otting to succeed in convincing banks to serve the credit needs of Americans who now rely on nonbank lenders, he will likely have to use more than “encouragement.” Perhaps he can find the “iron fist” that his predecessor always claimed was in the agency’s “velvet glove.”

Jim Wells

Jim Wells

Jim Wells spent over 30 years in the financial industry, in the U.S., U.K., Canada, Africa and the Middle East, most of it expanding access to financial services for consumers of modest means unserved, underserved or ill served by banks.

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