There is a better way to regulate small loans
Innovation in online loans has moved consumers away from traditional payday lenders. And while it’s a safer bet, the change has also sparked a flawed political conversation about online lending that focuses on the wrong thing: capping interest rates.
Rather, lawmakers and regulators should explore ways to encourage the responsible use of technological innovations, underpinned by a strict code of conduct, to deliver financial services to underserved consumers.
Instead of one-time APR pricing that doesn’t make sense, Congress should focus on legislation that encourages more bank-fintech partnerships; and the development of new financial products, which do not rely solely on credit scores, to expand access to more borrowers.
The recently introduced Fair Credit Act for Veterans and Consumers extend a 36% interest rate cap (currently just under the Military Loans Act) to all consumers.
However, the proponents of the proposal willfully ignore the fact that a healthy economy needs a wide range of readily available credit options – for both good and bad times – to ensure the financial well-being of consumers.
Setting an interest rate cap means ignoring the negative ramifications for millions of unprivileged individuals and families who could lose access to credit.
Take the example of the Federal Deposit Insurance Corp.’s low-value loan pilot program, which kept rates at 36% or less, and lasted two years until 2009. After the program ended, many lenders have stopped offering these loan products to non-privileged borrowers because they were simply not economical for financial institutions. The same would be true for online lenders if this bill were to pass.
Complying with the avalanche of new regulations since the 2008 financial crisis created violent competetion among banks and financial firms for prime borrowers, while they are less willing to extend credit to non-senior borrowers.
Millions of creditworthy Americans have a credit rating below the prime rate. A FICO a score below 700 is considered poor or only fair, making it difficult, if not impossible, to obtain short-term, low-value, vital credit from traditional financial institutions.
This exclusion from credit is self-perpetuating, as consumers may find it difficult to overcome financial challenges without access to credit and may experience further deterioration in their credit profile.
Non-banks intervened to meet this largely unmet but very important need. But imposing a ceiling rate will be a brake on the granting of credit.
A World Bank Research Paper 2018 rate caps entered into often have “significant unanticipated side effects,” including a decrease in the supply of credit and lower approval rates for small, at-risk borrowers.
What’s more paper 2017 by two Federal Reserve economists noted that “unprivileged consumers in low-rate states had fewer consumer loans because low rate caps made those loans unavailable for riskier, non-senior consumer loans.” .
Advocates of rate caps say their goal is to curb abusive lending practices. But this will not be done through poorly thought out legislation.
Underserved Americans deserve better options. It would be reckless to deny them credit when many Americans are not well prepared to manage even small unforeseen expenses.
FDIC 2017 national survey of unbanked and underbanked households noted that 18.7% of U.S. households were underbanked. Which means they had an account at an FDIC insured institution, but they were also using “another financial service provider,” which includes small dollar loans from online lenders.
A 36% rate cap applied to all active duty members also caused Financial difficulty. Lawmakers should be careful to consider the effects of the law on military loans, because recent polls and studies indicate that the military suffers under the MLA.
It will take innovation, combined with the promulgation of industry best practices, to ensure consumer protection without creating a ban.
Lawmakers should work with regulators – with input from industry – to expand the means for lenders to test new products and innovate faster to promote economic empowerment and financial inclusion.
The Treasury Department Noted that online and mobile-based platforms take advantage of new types of credit data and analytics, enabling them to provide loans to “segments of consumers and small businesses that would otherwise not have access on credit ”.
Additionally, a technology-driven approach (digitizing customer acquisition, origination, underwriting and servicing processes) provides these lenders with a smoother customer experience than traditional lenders.
These features reduce expenses, which can lower the cost of credit and expand access. This leads to the following solution: promoting partnerships between banks and financial technology companies.
One side (banks) brings strong customer relationships and low investment costs, while the other (fintechs) has advanced technical capabilities. Such bank-fintech partnerships to contribute financial inclusion by increasing access to savings, loans, financial planning, and payment products and services.
These partnerships are essential because US retail banks close branches at the fastest pace ever: 1,947 closings in 2018 alone. In addition, consumer banking habits have shifted in favor of online and mobile banking options.
Community banks need to partner with FinTech companies to keep up with their larger competitors. Otherwise, many community banks risk closing their doors, creating banking deserts that would deal a major blow to greater financial inclusion.
Rather than imposing price caps, a better way to ensure consumer protection is to adopt and scale up strong industry best practices.
These should include requirements such as full disclosure of all loan terms in a transparent and easy to understand manner; never engage in unfair, abusive or deceptive activities; ensure that payments are authorized and processed in accordance with federal laws; and ensure that consumers fully understand the options for sustained loan use.
Payday loans are a thing of the past. There are now better products available on the market to serve Americans.
These products offer longer terms, lines of credit, and principal repayment features that allow the borrower to prevent interest from accumulating with a payment plan. There is a need to support safe lending practices.
Fixing tariff ceilings is not a unique answer. It ignores the more practical solutions.