Fintech companies that lend through bank partners may face more scrutiny from state regulators following the repeal of a federal banking rule, industry experts said.
On June 30, President Joe Biden signed the congressional repeal of the "true lender" rule enacted in December 2020 by the Office of the Comptroller of the Currency under the administration of former President Donald Trump. The rule gave safe harbor to fintech lenders making loans in partnership with federally chartered banks, treating the bank rather than its nonbank partner as the "true lender" if the bank is named as the lender in the loan agreement or it funds the loan as of the date of origination.
Online lenders have used these partnerships to avoid the hassle of obtaining individual state licenses and lend nationally, but critics have viewed the true lender rule as displacing state regulators and sheltering predatory lending by letting nonbank lenders use their bank partners to lend at interest rates exceeding state limits, as Michael Calhoun, president of the Center for Responsible Lending, wrote in a June article published by the Brookings Institution. The attorney general for Washington, D.C., accused online lender Elevate Credit Inc. of doing just that in a June 2020 lawsuit.
Without an explicit federal rule, progressive states such as Illinois, New York, California, Massachusetts and Colorado have gained more leverage to enforce their local lending laws and inspect bank-fintech partnerships in the name of consumer protection, according to banking industry lawyers.
Illinois is the most aggressive state pursuing stricter lending laws so far, said Kimberly Monty Holzel, a partner at Goodwin Procter who advises on fintech. The state moved to challenge the OCC true lender rule nearly three months before its repeal with the Predatory Loan Prevention Act, which became law March 23. The law applied the national 36% interest rate cap on loans for active-duty service members and their families to most consumer loans in the state.
Illinois law also has particularly strong language around interest rate evasion, which may be preventing companies with bank partners from marketing high-interest loans in the state, according to Jacqueline Collins, who chairs the state senate's Financial Institutions Committee and co-sponsored the act. Collins said fintech companies have a place in the market, but they need to abide by the state's consumer protection laws, which strive to help prevent people, especially low-income consumers in Black and brown communities, from getting trapped in cycles of debt.
"I welcome innovative financial products to Illinois — as long as they're not just wrapping old-fashioned predatory loans in a shiny new package," Collins wrote in an email.
While several well-known digital lending platforms, such as those operated by SoFi Technologies Inc. and LendingClub Corp., have begun issuing loans through newly acquired national bank subsidiaries, many others still fund their loans through bank partners such as Cross River Bank and Celtic Bank Corp.
With the overturn of the rule, banks will find it harder to navigate partnerships with fintechs, and it may deter lending activities in the more progressive states, said John Popeo, a partner at New York-based financial services consultancy The Gallatin Group.
"I think [the repeal] just allows uncertainty to persist with respect to bank/fintech partnerships and lending generally," Popeo said.
The rule appeared to be on shaky ground from the start. Earlier in 2021, the Biden administration signaled that the true lender rule would be weakened or repealed outright, and in May, the Treasury Department replaced then-acting Comptroller Blake Paulson, who had defended the true lender rule in April, with Michael Hsu. Analysts said at the time it was an unusual move, and Paulson's support of the rule might have led to his removal.
Another wrinkle for securitization
For digital lenders who package and sell loans originated from their platforms as asset-backed securities, an additional concern is whether the back-and-forth in lawmaking will weaken the appetite of investors in the secondary market, said Garry Reeder, CEO of the American Fintech Council. The trade association is guided by an executive committee composed of digital lenders including SoFi, LendingClub, Marlette Funding LLC, Prosper Marketplace Inc., Upstart Holdings Inc., challenger bank Varo Bank NA and Cross River Bank. More than 75 fintech companies and lenders belong to the group.
"Practically, they've been operating exactly the same, but it's really [about] the ease with which investors have been willing to buy these securities," Reeder said.
Investors in the ABS market tend to be wary of securities that may cause legal disputes in different jurisdictions, since loans from various states could be lumped into the same securitization and raise the risk profile of the package as a whole by affecting loan contracts. During the legal battle around the case of Madden v. Midland Funding LLC, the cost of digital lender ABS was higher, particularly for loans originated in the states covered by the Second Circuit Court of Appeals, and in some cases, investors avoided the asset class entirely, Reeder said.
"From a legal perspective, our advice remains more or less the same. Maybe the risk is a bit higher without that rule to rely on, but our advice has always been that the banks should be more involved than just funding the loan," Holzel said. For example, banks are advised to retain some of the credit risk by holding on 5% or 10% of the loans to be sold through their fintech partners, and they should be making underwriting decisions, or at least be in control of the criteria for vetting borrowers, she added.
For Illinois' Collins, the uncertainty created by a regime of state-set interest limits will continue until federal lawmakers step in.
"The solution to the problem of rent-a-bank lending is for Congress to pass a national interest rate cap. Until then, each state will have to tackle the problem based on the circumstances of each particular case," Collins wrote.