The proliferation of P2P marketplace, and most importantly online lending brings a competitive challenge for existing financial institutions that is here to stay. Its meteoric rise has provoked regulators around the world to deliberate on the new models of oversight needed to benefit consumers and contain credit risk ahead of the next financial downturn, according to two researchers at the Harvard Kennedy School of Government’s Mossavar-Rahmani Center.
In their latest paper, “When Markets Quake: Online Banks and Their Past, Present, and Future,” Marshall Lux and Martin Chorzempa write the first comprehensive study of the evolution of online lending and grapple with the question of its sustainability. As policy develops under a new administration, Lux and Chorzempa remain hopeful about the industry’s long-term success, mostly through partnerships with existing financial institutions that leverage each other’s comparative advantages and a focus on populations that have little access to credit today. Their analysis drives a series of recommendations for regulators and lawmakers to strike the balance between access, affordability and risk management.
The study is summarized in the following points:
I. Allow Compliance Flexibility
The report advocates that consumer protection laws avoid legalistic compliance with an alphabet soup of regulatory bodies’ often contradictory guidance and excessive focus on disclosure. Instead, regulators should focus on the end impact for the consumer, leveraging new technologies to empirically test new products through pilot programs.
The Consumer Finance Protection Bureau (CFPB) is an example Lux and Chorzempa cite as already taking steps towards embracing data-driven and innovative regulation through initiatives like Project Catalyst, which gives entrepreneurs a chance to engage it in informal discussions to identify issues early on.
II. Harmonize State Lending Laws
Lux and Chorzempa contend that while states have beneficial laws aimed at protecting residents from unfair practices, constantly shifting inconsistencies across states creates regulatory burdens that end up being paid for by borrowers and restrict entry of new firms. They recommend online lenders and their advocacy organizations engage with organizations such as the Conference of State Banking Supervisors to harmonize lending laws as much as possible.
III. Raise Usury Caps
Some states should also consider raising usury caps and simplifying usury laws, according to Lux and Chorzempa’s study. For the largest underserved population for financial services, a reasonable interest rate to compensate a lender for the associated default risk can be above state usury caps, which are often far too low for lenders to consider customers outside of prime. Credit card banks, payday lenders and national lenders can essentially ignore state usury laws, so these restrictions appear to have little teeth as it is.
IV. Disparate Impact Guidance Needed
Rules that try to ensure that lenders are not implicitly discriminating against certain borrowers, like the Equal Credit Opportunity Act (ECOA), lack clarity and pose serious risks for online lenders and those using machine-learning algorithms to improve their underwriting, according to Lux and Chorzempa. The FTC approaches each practice with a case specific inquiry, so it may be difficult ex-ante to know if a certain underwriting practice puts a lender at risk of legal liability. Lux and Chorzempa advocate for more detailed definitions with clear tests that lenders can use to prove that their practices do not have disparate impact.
V. Increase Funding Transparency
Lux and Chorzempa argue an interagency body should study the use of leverage in the purchase of marketplace-originated loans and follow the flow of funds to ascertain their ultimate source. Real financial stability risks lie in the leverage and lack of visibility on the funding side of marketplace lenders. Transparency at the loan level should thus extend to funding, at least for regulators, as it’s probable that regulated banks are the ultimate providers of funds and leverage.
The full report can be downloaded here.