In May of 2015, a panel of the Second Circuit Court of Appeals came to the eyebrow-raising conclusion in a case called Madden v. Midland that perfectly valid loans made by a bank could be transformed into illegally usurious loans if sold to a nonbank after the fact.
Most legal observers, including the Obama administration’s solicitor general, concluded that the Second Circuit had probably erred in its reading of the “valid when made” doctrine. Nevertheless, more than 100 consumer and civil rights groups are now urging Congress not to reverse the impact of the Madden ruling.
I have been, far more often than not, on the same side of policy issues as the leading consumer and civil rights groups. But I disagree here: Madden is not just legally wrong; it is also bad public policy, because it moves us further away from creating a more effective and inclusive financial system. Bipartisan, bicameral proposals have already been introduced in Congress to fix Madden. Congress should pass them.
To understand why, it’s useful to take a step back.
Shortly after the Dodd-Frank Act was passed, I was asked by now-Sen. Elizabeth Warren to join a small team at the Treasury Department that was standing up what would become the Consumer Financial Protection Bureau.
The goals that brought me to Washington are the same that underlie the CFPB’s mission statement even today: to help consumer finance markets work for the American people. Like most in financial services, I was deeply concerned that the industry I had worked in my entire career had not only failed to make lives better for a great many people, but had instead made them worse.
Happily, legislative reforms and the hard work of management teams and regulators alike have served to allay many of the worst pre-crisis abuses, and the financial system today is dramatically more transparent, better capitalized, and more profitable than when I left Wall Street for public policy back in 2009.
Even after the worst pre-crisis excesses have been curbed, though, stubborn problems persist. The most unfortunate of these is the inefficiency with which consumer finance markets meet the needs of America’s large and underserved population of low-income working-class families. For low-income Americans, it’s still difficult and friction-filled to save and invest; payments are still too expensive and slow; and credit offerings still too often create more chutes (e.g., debt traps for the unwary) than ladders (e.g., sensible financing to grow a business, send your kids to college, or own your own home).
Solving these problems is difficult. They persist because we must simultaneously solve three underlying issues: (1) harnessing the structural advantages of the mainstream financial system to the benefit of the underserved; (2) solving long-standing operational problems that render it too expensive to serve low-income populations; and (3) creating a fair playing field for free-market competition.
Madden is a step backward on all three issues.
First, Madden limits banks — especially small ones — from benefiting from mainstream global capital market demand when it comes to otherwise underserved borrowers.
Too often, seemingly logical financial products for underserved communities fail because they cannot scale efficiently. One of the reasons for this lack of scalability is that new ventures can find it difficult to tap into large, low-cost reservoirs of global capital and risk appetite. Seemingly blind to this reality, Madden instead makes it more difficult for banks to sell assets to nonbank sources of capital. Given that global nonbank balance sheets are many times larger in aggregate than the consumer assets of American banks, this creates a thumb on the scale against banks lending to lower income consumers, particularly for the vast majority of banks that are relatively small and therefore are appropriately the most concerned about the policy-induced illiquidity of the consumer assets they originate.
Second, Madden makes it more difficult for banks to partner with nonbank technology firms to solve real, longstanding operational problems in serving low-income populations. Because low-income customers skew toward smaller-ticket transactions (whether in lending, saving, investing, or payments), providers must be especially attentive to reducing unit costs. Technology breakthroughs — in analytics, identify verification, payments, data infrastructure, among others — hold the promise of step-change reductions in costs, and therefore the hope of rendering previously commercially unreachable populations viable to serve at lower price points.
Realistically, though, technology development of this kind is not in the capability set of the vast majority of banks, particularly small ones; and technology firms, by contrast, lack the many structural advantages of regulated banks. Finding creative and constructive ways to partner, therefore, is the surest path to solving some of these longstanding operational problems. By putting sand in the gears of one the facets of these joint ventures — the transfer of assets from one partner to another — Madden unnecessarily risks some of the promise and potential of financial technology.
Finally, Madden doesn’t actually solve any conduct problems in the sector, but it does create an unfair playing field. Recall that the only loans that Madden impacts are loans that a bank can lawfully originate today, under the myriad — and in my opinion, appropriate — constraints imposed by Congress, the CFPB, and the prudential federal and state regulators. Madden doesn’t change what a bank can lawfully do; it merely creates a tailwind for those banks that can comfortably and permanently hold a loan on their own balance sheets, and a headwind for smaller banks that cannot or should not.
In short, Madden achieved nothing to advance a sensible consumer protection agenda, but instead set back the financial system’s long-overdue progress toward efficiency and inclusion. Congress should reverse it.