Compliance challenge of collaborating with online lenders
The success of online marketplace lenders is motivating banks to find ways to partner with these companies, acquire them, or duplicate what they see happening in this new industry. However, as banks look to initiate that collaboration, the task has been made more difficult by last November’s advisory letter from the Federal Deposit Insurance Corp. (FDIC) on how to manage the risk of purchased loans from third parties.
The letter “basically says that banks getting into investing in marketplace loans will need to have processes in place to make sure that they can do due diligence on the loans and the underwriting appropriately,” says Tom Nolan, practice leader for global finance at K&L Gates LLP, Washington, D.C. In effect, bankers will have to evaluate the marketplace platforms and how they operate to make sure that all relevant banking and consumer regulations are followed, Nolan explains. They will even want to know about the vendors to the platform, such as loan servicers, to make sure there are no hidden risks there for the bank.
The new FDIC guidance raises the prospect that loans originated by online marketplace lenders will have to be underwritten a second time by the bank, which is making matters far more complicated than they need to be, according to Linda McGreevey, president and CEO of the Online Lenders Alliance, based in Alexandria, Va. “You’re supposed to be able as a bank to manage your risk – not avoid all risk,” McGreevey says.
Regulators have been concerned for some time about the increasing reliance of banks on outsourcing to cut costs and they have issued guidance they say should help make sure those relationships have been managed properly. During 2012 and 2013, for example, the FDIC, the Office of the Comptroller of the Currency (OCC), the Consumer Financial Protection Bureau (CFPB) and the Federal Reserve System all issued either guidance or bulletins on mitigating third-party risk.
The compliance task facing both banks and their lending partners is extremely complicated, “a Gordian knot that has to be unwound,” and not to be taken lightly, according to Todd Baker, managing director at Broadmoor Consulting LLC, based in San Francisco. To hammer home the point, regulators have made third party and counterparty risks “a big focus” of compliance examinations in recent years, Baker says.
Third party due diligence now has to focus on how loans are originated, how they are serviced and how collections are handled, according to Baker. Banks must also look at how the automated underwriting works and be comfortable with its ability to properly evaluate the sophisticated analysis based on data that goes into determining the credit worthiness of borrowers.
Usury Preemption Threatened
Just as bankers look to online marketplace lenders to grow their consumer and small business lending, the online companies look to such as WebBank of Salt Lake City, Utah and Cross River Bank of Teaneck, N.J., for compliance help. “The banks take care of making sure the loans are originated properly so anyone that buys them can feel comfortable the compliance side is a go,” says Baker. Importantly, the banking partner provides the online lender with pre-emption from many laws, including state usury laws that set caps on interest rates.
The problem is that the ability of banks to give marketplace lenders preemption on usury rates was thrown into question last year in a ruling by the U.S. Circuit Court of Appeals for the Second Circuit in the case of Madden v. Midland Funding. The court ruled that federal exemption protections given to credit card companies that use higher interest rates than those limited by state usury laws do not apply to buyers of credit card debt. The case was appealed to the U.S. Supreme Court.
In a surprising move on March 18, the Supreme Court asked the U.S. Solicitor General for his views on the case and how he thought the court should rule before deciding to hear the case. “It is likely the Solicitor General will reach out to various banking agencies, the Fed and probably CFPB and get their views and how they think the federal government should respond,” says Richard Eckman, a partner at Pepper Hamilton in Wilmington, Delaware. A response from the Solicitor General is due in May.
If, based on the Solicitor General’s response, the Supreme Court decides to take the case, and ultimately decides to uphold the circuit court decision, “it could spawn a host of class action lawsuits challenging the rights of holders of such loans to collect interest at the rates made by the originating bank,” Eckman says.
Despite significant third party compliance issues, banks are moving ahead to meet the competitive challenge from online marketplace lenders by “giving a lot of thought to how they can best participate in the market,” Nolan says, noting that some banks will want to partner with a marketplace lending platform on a white labeling basis, in which the bank’s name appears in all communications with the borrower. Others may want to develop their own technology in house. Or, it may be less expensive to acquire an online lender with the required capability, especially given the decline in valuations for those companies, according to Nolan.
Banks and marketplace lenders have already set up a number of strategic alliances. WSFS Bank of Wilmington, Del., agreed in 2013 to originate and refinance student loans using LendKey, a New York-based marketplace lender. San Diego, Calif.-based Union Bank in 2014 decided it would buy loans originated by San Francisco’s LendingClub, a major online marketplace lender. In 2015, Premier Community Bank of Hillsboro, Ore., agreed to originate loans using the marketplace platform of Portland-based Mirador Financial.
Perhaps the most significant partnership to date is the one announced last year between New York City-based JPMorgan Chase & Co. and OnDeck Capital Inc., a New York-based marketplace lender specializing in small business loans. Working together, the two partners were able to incorporate Chase’s underwriting protocols into OnDeck’s technology, according to Julie Chen Kimmerling, executive director of Chase Business Banking, based in New York. “The credit risk appetite is entirely determined by Chase and, frankly, is within our current risk appetite” in small business lending at the bank, she says.
Importantly, OnDeck’s credit evaluation and underwriting of Chase customers for offers from the bank “is not a duplication of efforts,” says Brian Geary, head of bank partnerships at OnDeck. “What we bring to the table is innovation in both customer experience and credit scoring.”
The partnering companies have also worked to make sure the customer experience meets Chase’s requirements. “This is a Chase product for Chase customers and no matter which part of the experience is handled by OnDeck or Chase, the entire experience end-to-end is vetted as a Chase experience,” Kimmerling says. After completing the current pilot phase, Chase expects to offer loans up to $250,000 by invitation only to small businesses that are already clients of the bank. Borrowers who receive offers will be able to apply and receive funding the same or next day.
Another way for banks to address third-party compliance issues is to build an in-house marketplace platform, the approach taken by Boston-based Eastern Bank, New England’s largest small business lender, to profitably make more loans under $100,000.
Mr. England is a contributing writer to BAI Banking Strategies and the author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance.