There's a better way to regulate small-dollar lending
Innovation in online lending has shifted consumers away from traditional payday lenders. And while that’s a safer bet, the shift has also sparked a misguided policy conversation around online lending that is focused on the wrong thing: capping interest rates.
Lawmakers and regulators should instead be exploring ways to encourage the responsible use of technological innovations, underpinned by a strict code of conduct, to provide financial services to underserved consumers.
Instead of one-size-fits-all APR pricing that does not make sense, Congress should focus on legislation that encourages more bank-fintech partnerships; and the development of new financial products, which don't rely solely on credit scores, to expand access to more borrowers.
The recently introduced Veterans and Consumers Fair Credit Act would extend a 36% interest rate cap (currently just within the Military Lending Act) to all consumers.
However, the proposal’s sponsors are willfully ignoring the fact that a healthy economy needs a broad range of readily available credit options — for both good times and rough times — to ensure consumers’ financial well-being.
Fixating on an interest rate cap means ignoring the negative ramifications for millions of nonprime individuals and families who could lose access to credit.
Take the Federal Deposit Insurance Corp.’s small-dollar loan pilot program, which kept rates at 36% or less, and ran for two years until 2009. Once the program concluded, many lenders stopped offering these loan products to nonprime borrowers because they were simply not economical for the financial institutions. The case would be the same for online lenders if this bill is passed.
Complying with the avalanche of new regulations since the 2008 financial crisis has created fierce competition among banks and financial companies for prime borrowers, while they are less willing to extend credit to nonprime borrower.
Millions of creditworthy Americans have a credit score below prime. A FICO score below 700 is considered poor or only fair, making it difficult or impossible to obtain vital short-term, small-dollar credit from traditional financial institutions.
This credit exclusion is self-perpetuating, as consumers can find it difficult to address financial challenges without credit access, and can suffer a further deterioration of their credit profile.
Nonbanks have stepped in to address this largely unmet but very important need. But imposing a rate cap will be a disincentive to making credit available.
A 2018 World Bank research paper concluded rate caps often have “substantial unintended side-effects,” including shrinking credit supply and lowering approval rates for small and risky borrowers.
In addition, a 2017 paper by two Federal Reserve economists noted that “nonprime consumers in low-rate states had fewer consumer finance loans because low rate ceilings made such loans unavailable to riskier nonprime consumer finance loans.”
Proponents of the rate cap say their goal is to rein in abusive lending practices. But that will not be achieved through poorly thought-out legislation.
Underserved Americans deserve better options. It would be foolhardy to deny them credit when many Americans are not well prepared to handle even small unexpected expenses.
The FDIC’s 2017 National Survey of Unbanked and Underbanked Households noted that 18.7% of U.S. households were underbanked. Meaning they had an account at a FDIC-insured institution but also used "an alternative financial services provider," which includes small-dollar loans from online lenders.
A 36% rate cap as applied to all active-duty service members has also caused financial hardship. Legislators should be careful to consider the effects of the Military Lending Act because recent polls and studies indicate service members are suffering under the MLA.
It’s going to take innovation, combined with promulgating industry best practices, to ensure consumer protection without creating prohibition.
Lawmakers should work with regulators — with input from the industry — to expand ways for lenders to test new products and innovate faster to promote economic empowerment and financial inclusion.
The Treasury Department noted that online and mobile device-based platforms are taking advantage of new types of data and credit analysis, allowing them to make loans to “consumer and small business borrower segments that may not otherwise have access to credit.”
Furthermore, a technology-focused approach (digitizing the customer acquisition, origination, underwriting and servicing processes) provides such lenders a more seamless customer experience compared to traditional lenders.
These features reduce expenses, which can lower the cost of credit and expand access. This leads to the next solution: promoting partnerships between banks and fintech companies.
One side (banks) brings strong customer relationships and low capital costs to the table, while the other (fintechs) possesses advanced technical capabilities. Such bank-fintech partnerships contribute to financial inclusion by increasing access to savings, loans, financial planning, as well as payment products and services.
These partnerships are key as U.S. retail banks are closing branches at the fastest rate on record: 1,947 closures in 2018 alone. In addition, consumers’ banking habits have evolved in favor of online and mobile banking options.
Community banks need to partner with fintech firms to keep up with their larger competitors. Otherwise, many community banks face going out of business, creating banking deserts that would be a significant blow to greater financial inclusion.
Rather than imposing rate caps, a better way to ensure consumer protection is through the widespread adoption and enforcement of robust industry best practices.
These should include requirements such as fully disclosing all loan terms in a transparent and easy to understand manner; never engaging in unfair, abusive or deceptive activities; ensuring payments are authorized and processed consistent with federal laws; and ensuring that consumers fully understand the options for sustained use of loans.
Payday lending is a thing of the past. There are now better products available in the marketplace to serve Americans.
These products offer longer terms, lines of credit and principal pay-down features that allow the borrower to stop the interest from accruing with a payment plan. Supporting safe lending practices is necessary.
A fixation on rate caps is not a one-size-fits-all answer. It ignores more practical solutions.