Time for Online Lenders to Get Serious About Regulation
State officials in California have asked top online lending firms a series of probing questions regarding their compliance with laws and regulations dealing with referral fees, bank partnerships, fair lending and other sensitive issues.
Illinois, California and New York are all taking initial steps to try to crack down on borrower abuses in the fast-growing digital lending marketplace. The states are facing pressure to intervene because federal agencies have yet to take decisive action.
The abrupt resignation of the firm's founder and CEO, under a cloud, seems likely to fan investors' growing fears about the marketplace lending sector. It could also hasten regulatory scrutiny.
With the focus on alternative small-business lending growing more and more intense, the threat to innovation is not just from over-regulation. It is also from a number of new small-business lenders that are indeed unscrupulous and predatory in their practices targeting cash-strapped businesses.
Here I am focusing predominantly on merchant cash advance businesses and other business-to-business lenders which are earning a reputation for adding to businesses' long-term financial difficulties when providing short-term financing. Their misguided pricing and other predatory practices are squandering these lenders' chance to play a constructive role in alternative lending's legal and regulatory future. This miscalculation can have devastating effects on future innovation in small-business lending.
Some city and state governments are already focusing efforts on online small-business lenders, which may put the practices of MCA companies even more under the microscope. In Chicago, Mayor Rahm Emanuel launched an initiative last year aimed at preventing small businesses from taking out loans they couldn't afford. The Consumer Financial Protection Bureau will likely pay more attention to unscrupulous small-business lenders after establishing a new position of assistant director for the CFPB's Office of Small Business Lending Markets.
Illinois, New York and California have moved to regulate this industry. The Illinois bill would bar online lenders from making loans in which the total monthly payments exceed 50% of the borrower's monthly net revenue. A separate requirement would require lenders to disclose the percentage of their loans that have defaulted. In addition, online small-business lenders based in other states would be required to obtain Illinois lending licenses. Unfortunately, it will not be long before an established set of differing and conflicting state regulations is limiting small-business lenders across the country, and frustrating innovation in the space.
But the industry is also taking note of bad apples. Stories of predatory practices whereby lenders are scouring Uniform Commercial Code filings for recent borrowers — identifying businesses in potentially dire need of funds — to entice them to take more on debt they can't afford has led other lenders to believe something must be done to protect consumers. Corporate Turnaround, a company that specializes in negotiating debt payment terms for small-business owners, is seeing an exponential rise in the number of clients coming in for help in consolidating multiple merchant cash advance loans and other debts. Many of these borrowers were likely in a tough place and may have been convinced to take on a short-term debt solution that resulted in long-term financial difficulty.
The broader sector of alternative lenders should be concerned about the effects a few companies are having on innovation and a potential regulatory response. Although more regulations can limit credit availability, some form of government response to the new small-business lending sphere is virtually a necessity to confront the dangers to some borrowers. Instead of waiting to see what happens, small-business lenders should take the initiative to work with Congress to develop sound regulations for the industry. Establishing industrywide disclosure requirements, rate limitations and other measures to prevent lender abuses will not only protect the small-business owners from catastrophic results, but also help to legitimize the industry.
The rapid growth of alternative small-business lending — with billions of dollars being lent and new lenders popping up every day — is reminiscent of the go-go years of the payday lending industry. Filling a desperate need for cash to those left out of the traditional banking system, the payday-lending marketplace ballooned to heights unimaginable in such a short span of time.
These MCA businesses and other business-to-business lenders, like the payday industry, tout relatively low defaults — some industry observers estimates defaults may be close to 15% — but the question becomes what happens to those 15% when they default? The sometimes heart-wrenching tales of those who cannot make payments on these loans are making their way into the media and have begun to generate a response from regulators, much as it did with the payday lenders.
As with any red hot market, quality control can be sketchy and a few bad apples can bring the wrong kind of attention to an entire industry. Many payday lenders were overly aggressive in the loans they made, in the collection efforts they used and the legal premises under which they operated. These lenders as a whole ignored the legitimate complaints and worked tirelessly to frustrate efforts to find regulatory and legal compromise. As a result, the payday loan industry and its customers have suffered from sometimes overly restrictive state and federal regulations that caused some lenders to abandon the market, leaving credit-deprived consumers with even fewer credit options. Had the industry been willing to work with the authorities while they were forming these regulations, the dialogue may have resulted in a better solution.
If they are not careful, these new small-business lenders will suffer a similar fate. The complaints of unfair practices and outcomes are starting to get louder, yet the lenders have not come to the table to discuss what is being done and what more can be done to protect the borrowers while also giving them access to credit they desperately need.
Some lenders have taken the prospect of regulation, and the need to engage with regulators, seriously. They admit what while they don't like a lot of regulation it is a necessity for any lending product. Lenders with this attitude, while in the minority, support industrywide disclosure requirements, rate limitations and other measures to prevent lender abuses, protect business owners and in turn legitimize the industry. Additionally, the Small Business Finance Association, an industry trade group, hopes to focus on the education of policymakers and customers.
However, while most companies act honorably and with the best interests of the customers in mind, the lack of oversight makes it possible for more reckless or aggressive players to do damage to both the customers and the image of the industry.
The industry's insistence on being self-regulated is not practical, realistic or advisable. Everyone benefits from the certainty of uniform rules. The mainstream financial services system operates this way for a reason. While it may be challenging, it is possible to regulate the industry but still allow for the innovation and risk-taking needed to serve this underserved market.
To make matters worse, as recently reported, a number of the larger players in this space, such as Prosper and OnDeck, have failed to meet profitability expectations. In the short term, this could put intense pressure on these lenders to employ even more aggressive loan-generating tactics that may result in a further increase in consumer complaints.
The maturing small-business lending industry must do more to create a public discourse highlighting how its innovative lending models really help small businesses thrive. They must also be open to making changes to address legitimate concerns. If they fail to do this, they will likely find themselves in the same business-crushing crosshairs as the payday lenders. The anti-payday-lending fervor severely limited the introduction of innovative lending solutions for already credit-starved consumers.
Without concerted action, small-business lenders could suffer a similar fate.
Kevin B. Kimble is the principal of KBK Consulting Group, and the founder and director of policy development of the Financial Services Innovation Coalition, a group advocating on behalf of a coalition of nonbank consumer lenders, small-business lenders and community groups.