Online Lending Under a Microscope

When a market experiences the type of explosive growth that alternative lending has experienced in recent years, it’s only a matter of time before it draws scrutiny from regulators and lawmakers.

What regulators are doing in Utah

A recent article by the Wall Street Journal revealed that regulators are looking into lending standards of leading alternative platforms such as Prosper and LendingClub. Of particular focus is the use of WebBank and other Utah-based banks for lending. Banks like WebBank make loans to borrowers and back the loans temporarily until an investor on an alternative platform ultimately takes over responsibility for the loan, usually within two days. Utah has no state usury limit, meaning that WebBank and others have no interest rate cap on their loans. In addition, WebBank’s legal status as an “industrial bank” in Utah means that it has not been subject to oversight by the Federal Reserve, which regulates the majority of state-chartered banks and bank holding companies. Critics of the current system argue that the partnership between banks like WebBank and alternative lenders means that the two entities are collectively acting as a bank and should be regulated as such.

U.S Treasury

The U.S. Treasury department is taking a broader scope. In the fall, the department issued a request for information on a variety of alternative lending companies. Among the topics the Treasury wanted insight on were how customers were marketed to, how the government could help innovation and how each platform managed the credit underwriting process. Over 40 companies responded to the inquiry, ranging from Cross River Bank to OnDeck. Even online payments giant Paypal was included and in a response, the company said it was “well regulated” under existing law. “[A]dditional regulation could stifle the innovation these products bring to the market and the benefits they provide to consumers and small businesses,” Richard Nash, Paypal’s Head of Government Relations wrote at the time. SoFi echoed a similar tone. The alternative student lending platform addressed the notion that it and its competitors are not subject to consumer lending laws and operate without oversight. “This is not correct,” SoFi wrote. “As a private education lender, SoFi is a covered person under Title X of the Dodd Frank Act and is subject to examination by the Consumer Financial Protection Bureau.” Other respondents, like Lending Club, also said consumer protection regulations offer borrowers protection.

Six regulatory themes emerge

The latest update to the inquiry is a response from the Treasury, where officials noted “six themes” that emerged from lenders’ responses. According to legal firm Manatt, Phelps & Phillips, the themes are:

1. Alternative lenders could do a better job to address small businesses.
2. Existing underwriting models haven’t been tested in a full credit cycle.
3. Credit underwriting algorithms are often seen as a black box.
4. Loan terms, conditions and warranties need better standardization and transparency.
5. Alternative lenders are developing more partnerships with banks and CDFIs.
6. Risk retention is a major topic of debate, something journalists have noted before.

It’s possible the Treasury will issue an update in the New Year, but exact details are thus far unknown. An unfortunate comparison Attention from regulators is pushing critics to make unfortunate comparisons between alternative lenders and the mortgage lenders of yesteryear. The process in which industrial banks profit by collecting fees on loans that they then pass along to be packaged as securities gives some onlookers an eerie feeling of déjà vu. Without the appropriate oversight, this type of model can quickly turn into the out-of-control and irresponsible subprime lending culture that was responsible for the 2008 Financial Crisis. During the housing bubble, lenders raked in record profits by lending to anything that moved, knowing that the mortgages would quickly be passed along to Fannie Mae or Freddie Mac for securitization and would not be kept on the books in the long-term.

What’s next?

Despite the growing cloud over the space, regulatory scrutiny could actually serve to boost the public’s confidence in the new industry.

If alternative lenders continue to uphold a fair and honest level of practice, government inquiries and investigations will churn up an environment that consumers can continue to trust. Rules, regulations and oversight are simply part of the game in the world of finance to prevent fraud and criminality and protect the interests of consumers. If anything, this type of attention serves as a further indication that alternative lending is making a major disruptive impact on the financial world.