Regulating Fintech Lenders: A Win for Borrowers?

March 3, 2017

Buried in New York Governor Andrew Cuomo’s just-released proposed budget for 2017-2018 is an increase of state licensing authority over “fintech” lenders—lenders to consumers and small businesses that operate online and largely outside of regulatory purview. Though innovative fintech lending is helping expand access to credit for consumers and small business borrowers, the sector’s high interest rates and often- unfavorable loan terms indicate that increased regulatory attention should be welcomed.

As the banking sector has recovered since the financial crisis, the recovery hasn’t been uniform—the challenge for borrowing is concentrated in smaller loans. The particular challenge of obtaining small loans from traditional sources like community banks has meant that entrepreneurs and households have two options: either tapping into personal credit options, including savings and credit cards, or the new opportunities available through fintech lending.

Fintech lenders have stepped into the gap in the last few years, but the initial data coming out about the nascent industry shows that interest rates are higher and consumer satisfaction is lower than what borrowers are able to get from the more formally regulated banking sector. Still, many argue that the tradeoff of increased credit in exchange for more expensive loans is worthwhile.

This all sounds suspiciously like the arguments made for the subprime mortgage market: why shouldn’t consumers who have worse credit be able to benefit from the American Dream just like consumers with higher FICO scores? But the predatory practices of that industry should ring warning bells for anyone paying attention to the emergence of fintech lending, and encourage policymakers to find smart regulatory solutions that allow for innovations while preventing predatory history from repeating itself.

The promise of fintech is, ultimately, that the borrower should benefit from a more efficient borrowing and servicing process, without having to actually sit down with a human being at a bank branch and wade through mountains of physical paperwork, and wait weeks for a response. Lenders operate online, are supposedly user-friendly and often provide a response to a potential borrower the same day.

The industry is growing: Investors are pouring money into fintech startups, with almost $14 billion invested in 2016, a 45 percent increase in funding from 2015. A California Department of Business Oversight survey of 13 online lenders found that their total business lending nationally increased from 12,868 loans totaling $403 million in 2010 to 240,277 loans totaling $2.94 billion in 2014, an increase of over 1,700 percent. The Federal Reserve’s 2015 Small Business Credit Survey found that 20% of all small businesses had applied to an online lender, including 30% of microbusinesses and 22% of firms with revenues between $100K – $1 million.

Fintech covers a wide range of lending, including peer-to-peer, merchant cash advance, marketplace lenders, and balance sheet lenders—but all have in common their use of online automated systems and proprietary algorithms to evaluate loan applications, and all are virtually unregulated. The algorithms are black boxes, leaving applicants with no room to appeal decisions or check for errors, and no regulator looking at the algorithms’ effects systematically. The problem is that small business borrowers usually have more in common with household borrowers than sophisticated larger business borrowers, meaning that they may not understand all of the terms and conditions of loans or be able to effectively compare loan offers.

Crucially, only 15% of firms surveyed by the Fed who had borrowed online were satisfied by their experience borrowing from an online lender, as compared to 75% of those borrowing from a small bank or 51% borrowing from a large bank—a highly significant spread. This was commonly due to unfavorable repayment terms and high interest rates: 70% of firms borrowing from online lenders reported that they were dissatisfied due to a high interest rate, and 51% reported dissatisfaction with unfavorable repayment terms.

Additional research has found that the debt burden for small businesses after borrowing from fintech lenders can balloon quickly– average monthly loan repayment for businesses that had borrowed from a fintech lender was nearly double (178%) the net income available to the owner, according to a recent report by the Opportunity Fund. In forthcoming research, I examine the different interest rates that the fintech lenders offer as compared to banks for similar quality loans, as well as the varied rates that are offered to businesses versus consumers, and find that in general fintech lenders offer more expensive credit.

There are a number of different proposals about how fintech should best be regulated. The Office of the Comptroller of the Currency has proposed a new special bank charter that would allow fintech lenders to become nationally-chartered entities, preempting state regulation but ‘harmonizing’ the entry of new firms into the marketplace. Under the National Bank Act, such banks would be covered by the interest rate exportation provision, which would mean that there would be no functional limit on the interest rate and related fees that such entities could charge, since they would rationally locate themselves in a state with lenient state law. Interest caps have been shown to be one of the simplest and most effective ways to protect borrowers from unaffordable loans, and the removal of this protection for fintech borrowers could cause a further explosion of high interest rates. That’s why state regulation may be best, and signs show that state regulators are starting to pay attention. In addition to the New York proposal, Illinois recently introduced a bill that focuses on small business lending specifically.

Given the Trump Administration’s all-out war on regulation, and the new makeup of the Treasury Department, it’s critical that states step up as regulators to ensure that any warning signs coming out of the fintech industry are addressed. Governor Cuomo’s initial moves should be supported, and other states should follow suit.