A recent bill In Colorado threatens to not only cut off low-income consumers from accessing credit but could risk starting a trend in other state legislatures. Lawmakers in other states should take heed and not follow suit.
Colorado consumers may see their access to credit tighten. The legislature “opted out” of a federal law that allowed non-Colorado state-chartered banks to set rates based on their home state, even if those rates were higher than permitted in Colorado. The risk to credit access comes at an inopportune time, as regular incomes could decline as the economy slows down.
Further complicating the situation is a rule passed by the Federal Deposit Insurance Corporation (FDIC), which allowed consumers greater access to small-dollar short-term loans. Before 1978, state-charters banks were at a competitive disadvantage to federally chartered banks because, unlike federal banks, state banks were subject to the usury laws of each state they operated in, not just their incorporation state.
This changed when Marquette v. First of Omaha Service Corp concluded that Section 85 of the National Bank Act entitled out-of-state state-chartered banks to the same usury exceptions as federal banks. Under this change, banks chartered in Idaho would only be subject to Idaho usury laws when operating in other states, while previously Idaho banks would be subject to Idaho’s and any state, they operated in’s usury laws.
The federal government concurred with the court and passed the Depository Institutions Deregulation and Monetary Control Act to clarify the decision and implement a policy framework. There was one caveat, though, states could choose to “opt out” of the Depository Institutions Deregulation Act (DIDA), a subsection of the whole bill. The implications will be state banks from out-of-state will be subject to the usury laws of “opt-out” states.
Perhaps an unintended consequence of the recent “opt-out” will be counteracting the FDIC’s “Madden fix,” rule named after Madden v. Midland Funding. The rule allowed for some loans that result from partnerships between banks and non-banks to charge interest at rates permissible to the banks even if not permissible to the non-banks. Because DIDA only applies to banks, non-banks are usually subject to the usury laws of the states they operate in, regardless of incorporation.
Non-banks tend to be uniquely capable of providing small-dollar and short-term loans to borrowers, many of whom are subprime. Subprime borrowers have higher loan default rates, presenting a greater risk to lenders who may not see a return on extensions. Higher rates accommodate this higher risk, but subprime borrowers are effectively cut off from credit without the ability to set rates past local usury caps. The partnership allows non-banks to extend loans to customers originating from state usury-exempt banks, which can have higher rates that better match the customer’s risk level.
Because the Madden fix relied on DIDA for its implementation, states that opt out of DIDA also lose the benefits of the Madden fix. Colorado lending laws will be returned to the far more legally ambiguous and less credit-friendly 1970s, with decades of work being undone.
Though currently, the number of states to opt-out of the DIDA is limited to Iowa, Puerto Rico, and now Colorado (unless the courts intervene), there is always the risk of this policy catching on with other state legislatures. We have already seen this happen with the 36 percent interest rate caps adopted in states across the country. Credit restriction policies have a nasty habit of becoming national trends if not confronted.
Because opting-out is so rare, the outcome of this decision in Colorado is still largely speculative. Still, if history is any indication, restrictions of credit will fall hardest on the lowest income. Short-term lending is a useful financial tool. Let’s not inadvertently hurt consumers by making a trend out of restricting credit access.
