Takeaways from Treasury’s Report on Online Marketplace Lending
Last Tuesday, May 10, the U.S. Department of the Treasury released the findings from its request for information (RFI) on the online marketplace lending industry announced in July 2015. The report is a commendable effort given the diversity of respondents, with more than half of its 42 pages containing an analysis of key issues gleaned from about 100 comment letters Treasury received last year.
Below are a few observations about the report:
Up to Speed
It is evident that Treasury endeavored to understand the various business models of online marketplace lenders, how they operate and their overall importance to consumer and small-business finance given the pullback from traditional financial institutions in serving both markets due to the financial crisis and the accumulation of financial regulations at both the domestic and international levels following the crisis.
Like the recent report from Office of the Comptroller of the Currency (OCC), Treasury recognizes the value of innovation within the financial services industry and provided thoughtful recommendations to facilitate the continued growth of the online marketplace lending industry while ensuring that platforms offer “safe and affordable access to credit for consumers and small businesses.” As Treasury rightly observes, partnerships between online and traditional lenders “may present an opportunity to leverage technology to expand access to credit further into undeserved markets,” and specifically referred to partnerships with Community Development Financial Institutions as a way to expand access to the underserved. Another way to expand credit access and drive rates down further: support open-data initiatives, such as by encouraging the Internal Revenue Service to automate its Income Verification Express Services.
A Call for Collaboration
Treasury recommended establishing an inter-agency working group for online marketplace lending that could include federal and state regulatory authorities. This proposal could address the fragmentation and inconsistent messaging that make it difficult for FinTech firms to navigate the current U.S. regulatory structure.
However, this recommendation should be approached with caution. Given the large number of regulators that Treasury would like to have at the table, it’s imperative to define the working group’s members and responsibilities at the outset: who is involved, the duties and responsibilities of the working group, its mandate (e.g., enforcement or just engagement?), each regulatory body’s role in the group and the issue(s) each regulator will tackle.
Transparency and clarity will go a long way toward credibility and efficacy, while preventing potential problems such as the risk that only one or a small handful of regulators influences the working group’s outputs or the ensuing confusion for online marketplace lenders over who exactly is regulating them and which regulator (or regulators) influenced the group’s output.
While Treasury is concerned about the safety and soundness of the online marketplace lending industry, the report also seems to advocate adoption of less-accurate credit scoring models by online lenders in order to prevent high-risk borrowers from paying higher rates due to a correction to the credit scoring model. Treasury’s concern that more accurate models may lead to higher rates for those thin- or no-file borrowers is understandable, but this position, in my view, contrasts with Treasury’s own recommendations to enhance safety and soundness as well as its encouragement of efforts to expand credit access to the underserved.
As the Treasury report states: “More accurate scores are not necessarily better for each individual borrower or groups of borrowers, although they may be lawful. For example, borrowers who are high-risk, but would have been misclassified as low-risk under a less accurate model, may be worse off when they are classified correctly (e.g., if they receive the same loan for a higher price).”
It further states: “Some privacy and consumer advocates have expressed concerns that in the event credit models become more accurate, the outcomes may lead to increasingly stratified outcomes. For example, some have argued that more accurate models will create a vicious cycle where those already disadvantaged will pay more for credit, and therefore be more likely prone to become financially fragile and default, and the cycle will repeat itself.”
As a few of the comment letters to Treasury stated, more accurate risk-based pricing could lead to greater financial inclusion and reduced rates, thereby lowering borrowing costs for those deemed “too risky” under older/less accurate models. In short, Treasury needs to provide further clarity on this, as the department seems to have contradicted itself.
Sample Size Is Important
The department appears to use lopsided statistics from a 2015 Small Business Credit Survey (the Survey) to make the case for greater protections for small-business borrowers. To be sure, a significant number of comments to Treasury called for such protections, and online lenders have made efforts to improve transparency through initiatives such as the Small Business Borrowers’ Bill of Rights and the SMART Box initiative launched by the Innovative Lending Platform Association. However, the report should have made clear that the statistics derived from the Survey on borrower satisfaction levels and reasons for borrower dissatisfaction were pulled from small sample sizes.
Additionally, the Federal Reserve Banks explicitly stated that the Survey “is not a random sample; therefore, results should be viewed as suggestive and analyzed with awareness of potential methodological biases.” The Survey also states that “caution should be taken when interpreting the results. The data are not a statistical representation of small businesses.”
While data derived from the Survey or any other surveys of online marketplace lenders are important to provide clarity for regulators, it is important to note their limitations, especially if the statistics are being used to back up major recommendations.
Consumer Protections for Small-Business Lending
Treasury is recommending that consumer protections be brought over to the online small-business side for business loans under $100,000. And while that is notable, it is unclear from the report what “evidence” Treasury is referring to in the following statement: “Further, stronger evidence indicates that small-business loans under $100,000 share common characteristics with consumer loans yet do not enjoy the same consumer protections discussed earlier.”
If consumer protections are added to the small-business lending space, and that’s a big “if,” early-stage businesses, in particular, may have a harder time gaining access to capital, especially if they are subject to ability-to-repay rules derived from consumer finance. This is not to say that Treasury is wrong in its view that additional protections are needed in the small-business lending space, but it is important for regulators and policymakers to make a distinction between small-business and consumer lending. Businesses need capital to expand and generate revenue, which is very different from consumers seeking finance to purchase products and services.
What Was Left Out
It’s important to note that Treasury’s report did not address some of the suggestions provided in the comment letters. Among these were a recommendation for a non-bank licensing framework for online marketplace lenders. To be fair, the OCC has been out in front on this issue with prior comments suggesting that there may be some sort of license in the works (see here and here). And while it makes sense that such a framework would come from the OCC considering its jurisdiction, the fact that Treasury’s report did not respond to this issue, despite touching on other considerations outside of its purview, is interesting nonetheless.
All in all, the report provides a good summary of the opportunities and challenges the online industry faces, along with practical recommendations that balance the need to encourage innovation with the need to protect consumer and small-business borrowers. I am hopeful that in the coming months Treasury (and other regulators) will continue to reach out to industry stakeholders to further inform their work towards developing appropriate regulatory frameworks conducive to the growth of the online marketplace lending industry.