If Lenders Can't Collect on Debts, There Will Be Little Debt
With GDP on the rise and unemployment down, the narrative of strong economic performance on average often overshadows the story of the underperforming segments of the American economy, such as the 47 percent of would-be low-income borrowers financially constrained by insufficient access to credit. Fortunately, a recent report by the U.S. Department of the Treasury offers proposals to help these Americans, laying out a series of recommendations to improve growth and financial inclusion through credit access.
The report—titled A Financial System that Creates Economic Opportunity: Nonbank Financials, Fintech, and Innovation—recognizes the increasingly important role of financial technology (FinTech) and nonbank financial institutions in bringing innovative financial opportunities to consumers. It also identifies material challenges new paradigms bring to federal regulators, such as how to help consumers enjoy access to new forms of credit while still protecting them from illegal products and bad actors. Three of the Treasury recommendations are particularly promising for the American consumer.
The first addresses a recent court case that could have deep repercussions on the lending industry involving the “valid when made” doctrine, a principle dictating that if a loan is transferred to a third party, such as a marketplace or peer-to-peer lender (P2P), in another state, that loan cannot be deemed invalid or usurious. This well-established standard for buying and selling loans on the secondary market expands and diversifies the pool of lenders, thereby broadening credit access for borrowers.
But the U.S. Court of Appeals for the Second Circuit dealt a serious blow to this principle last year in Madden v. Midland Funding, LLC. The case involved a customer who defaulted on a credit card loan originating from a national bank that was sold to Midland Funding, based in New York. The customer sued on the grounds that the loan was usurious under New York state law. Rather than recognize the valid-when-made doctrine, the Second Circuit ruled in Madden’s favor.
The Treasury report rightly asserts that the decision will diminish loan opportunities for consumers, because “the risk of litigation asserting violation of state usury laws” will deter “nonbank firms such as marketplace lenders . . . from purchasing and attempting to collect on, sell, or securitize loans.” The ruling has already made it difficult for state-based FinTech firms to partner with national banks to provide innovative loans. These non-bank lenders rely on nationally chartered banks to originate the tech-driven loans, which the FinTech companies then quickly buy and services. Without recognition of the valid-when-made principle, that becomes a much riskier proposition.
Congress could resolve this problem by codifying the valid-when-made practice into law. One such bill has already passed the House and is currently under consideration by the Senate Committee on Banking, Housing, and Urban Affairs.
The Treasury’s second important set of recommendations involves what is known as the regulatory sandbox: a framework where state and federal regulators allow firms to develop and experiment with new and innovative products in a less restrictive, but closely monitored, environment. The report puts it well: “The regulatory environment should… be flexible so that firms can experiment without the threat of enforcement actions that would imperil the existence of a firm.” Because regulation cannot keep pace with advances in FinTech, agencies are better serve consumers by providing leeway for innovators to create responsibly and develop products that foster financial inclusion. Arizona has taken the lead in this area, establishing a statewide FinTech regulatory sandbox program earlier this year.
Finally, the Treasury report endorses regulations that expand access by welcoming alternative credit scoring models. Typically, financial institutions rely on the “Big Three” credit bureaus—Equifax, Experian, and Transunion—when assessing consumer creditworthiness for mortgages, credit cards, auto loans, and the like. These bureaus use fairly limited data, such as lines of credit and loan payment history that may not capture the full picture of a consumer’s credit history and risk. But some FinTech companies have begun using alternative data models to provide more accurate and comprehensive assessments of borrowers, taking into account such factors as employment history and rent or mobile phone bill payment history.
Recognizing that alternative credit models could increase consumer access to credit and quality financial services, the Treasury report therefore encourages “regulators, through interagency coordination wherever possible, [to] tailor regulation and guidance to enable the increased use of these modals and data sources.”
The Treasury’s report is a great service to consumers and regulators alike. It recognizes the importance of raising the economic tide for all vessels through financial inclusion and greater access to credit, and it helps regulators navigate the challenging waters of protecting consumers while also promoting innovation.
