A version of this op-ed first appeared in American Banker and can be accessed here.
Regulators have thus far permitted online small-business lending to flourish with minimal oversight. But several recent developments suggest that may be changing.
Chicago Mayor Rahm Emanuel launched a citywide campaign in January cautioning borrowers about "predatory online lending," and the state of Illinois is working on a bill to rein in unsavory practices. Meanwhile, federal regulators have largely taken a wait-and-see approach. But the Treasury's July request for public input on marketplace lenders suggests that policymakers are keeping a close eye on the industry.
Many in the online lending industry are worried about the possibility that increased scrutiny could lead to regulations that stymie innovation. However, regulation doesn't have to put a chill on genuine innovation. Rather, enforced broadly and equally, regulation can protect borrowers from predatory practices while ensuring that online lenders don't have to choose between a race to the bottom on borrower protection standards and surrendering market share.
Online lenders funded an estimated $5 billion in small-business loans last year, a fraction compared to the $300 billion in outstanding small-business loans at domestic banks. However, online lenders' meager market share masks immense potential. Morgan Stanley puts their addressable market at $280 billion and predicts online lenders will grow 50% annually through 2020.
Unfortunately, this growth is partially underpinned by regulatory arbitrage -- particularly when it comes to borrower protections.
Indeed, many of these lenders originate loans online across myriad states but underwrite them in states like Utah, which lacks a usury cap. This results in the "rent-a-charter" model, which Goldman Sachs has called "the new shadow bank."
While marketplace lenders are subject to securities laws, these protections exist to safeguard investors, not borrowers. And safeguards such as the Truth in Lending Act often don't apply to small-business borrowers, even though they are often just as unschooled in finance as everyday consumers.
Instead, online small-business lenders are governed by a fragile latticework of state-by-state oversight. Some states, such as California, provide small-business borrowers moderate protection. Most provide little oversight of any kind.
It's true that light-touch regulation can benefit lenders as well as borrowers. Since online lenders are less encumbered by rules, they have experimented with more creative, automated underwriting techniques that allow them to make faster lending decisions. They've extended credit to a broader range of borrowers and in so doing utilized the seamless user interfaces that are hallmarks of Silicon Valley.
But regulatory arbitrage hasn't been entirely benign. As evidence, one need only look to some lenders' triple-digit interest rates, the proliferation of shady loan brokers and inadequate or nonexistent disclosure of price and terms. Some practices, such as brokers that brand themselves as impartial but take incentives to market certain lenders over others, resemble behavior seen in the run-up to the financial crisis.
All this merits responses from federal and state overseers. As regulators evaluate next steps, they should consider these five core principles.
1. Loan terms should be clear, concise and comparable.
Borrowers have no shot at making sound financial choices if they aren't given a complete picture of their loan terms. The problem is that some online lenders fail to offer tools that enable borrowers to compare online products to others, such as annual percentage rates. They may also obfuscate important features such as prepayment penalties. Most also include forced-arbitration clauses, requiring borrowers to surrender their rights to bring class-action lawsuits.
Regulators should thus require disclosures that are clear and concise and let borrowers decide what's best. Requiring lenders to disclose annual percentage rates and to compose standardized contracts in plain English would go a long way toward reducing complexity and helping borrowers make well-informed choices.
2. Lenders should make sure borrowers genuinely understand loan terms.
Modern behavioral economics shows that there are distinct limits to people's ability to internalize complex financial products. Viewed in this context, it's clear that the libertarian principle of "caveat emptor" is ineffective in financial services. "Caveat venditor" -- let sellers beware -- may be more sensible.
By this standard, lenders must go beyond disclosure to meet what former Treasury official Michael Barr calls an "objective reasonableness" test, making a reasonable attempt at helping borrowers understand risks and rewards of taking out high-interest rate loans before closing. Government agencies could provide clear guidance on this standard, including model disclosures. No-action letters could also be helpful tools, as they would allow regulators to assure lenders that new products are legal and that no enforcement action will be needed.
Better yet, given the complexity of loan products and the potential for buyers' remorse, policymakers should consider giving borrowers cancellation rights. They could be permitted to cancel a credit agreement within a few business days of the initial sign-up for whatever reason without penalty, similar to the "cooling off" standard in the United Kingdom.
3. Lenders must verify borrowers' ability to repay.
Lenders ought to ensure that they aren't facilitating debt traps or debt spirals. As with mortgages, lenders should be required to extend credit only after determining borrowers' ability to repay their existing debt burdens and additional financing without having to re-borrow or default. Lenders should also remove prepayment penalties so borrowers aren't discouraged from paying back their loans ahead of time.
In addition, lenders should be required to issue "payoff letters" within 48 hours. Borrowers need these letters when they refinance with other lenders at cheaper rates. Some lenders today are slow to issue these letters so they can continue drawing payments from borrowers for as long as possible.
Regulators could police outcomes by using their data-collection authority under the Dodd-Frank Act to "name and shame" lenders with the highest default rates. They should also highlight narratives of abuse alongside such data, as the Consumer Financial Protection Bureau has recently done with other sectors.
4. Lenders must handle big data with care.
Big data has created new potential for discrimination. Algorithms can parse public data to predict everything from users' race to their sexual orientation.
In keeping with long-standing equal credit opportunity laws, lenders should never base credit decisions on personal characteristics unrelated to borrowers' creditworthiness. Regulators ought to examine lenders' algorithms and marketing efforts to ensure they do not have a disparate impact on certain classes of borrowers.
Regulators should further monitor how lenders and brokers use borrowers' personal data and information. Neither should be allowed to sell borrowers' information to third parties without borrowers' permission -- a common practice today. And security systems guarding borrower information must be at least as strong as what banks offer.
5. Brokers must be governed by fiduciary duties.
As with investment brokers, loan brokers offering individualized advice should act in borrowers' best interest, respecting fiduciary duties of disclosure, loyalty and prudence. Brokers should disclose conflicts that compromise their impartiality, such as incentives from lenders to market higher-priced loans over others, and clearly break out the fees they add to loans. Brokers should further preserve impartiality and remain lender-agnostic by standardizing fees from lenders within loan products.
Self-policing alone cannot ensure that all lenders and brokers treat borrowers fairly. The five principles outlined above will help regulators smoke out abusive conduct. Enforcing them will require a centralized authority: otherwise, whack-a-mole regulation may only shunt poor practices to other areas. We should therefore consolidate responsibility for enforcement with the CFPB, a single agency grounded by experience policing similar abuses in other sectors.
From the way Silicon Valley talks about innovation, one might well conclude that it's always an unmitigated good. But that's a dangerous proposition in financial services. The heady years leading up to the 2008 crash taught us that today's financial ingenuity can become tomorrow's scandal. The crisis also made it blindingly obvious that financial innovation must be met with regulatory vigilance. Focused regulation is needed in the online lending industry. If it's done right, responsible actors have no reason to fear it. Rather, they should embrace it.
Brayden McCarthy is head of policy and advocacy at Fundera, an online marketplace that connects small businesses with financing, and was previously senior economic policy adviser in the Obama White House and Small Business Administration. Follow him on Twitter @btmccarthy.
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