Why it matters
In the Winter 2015 edition of the Federal Deposit Insurance Corporation's (FDIC) Supervisory Insights, the agency provided an overview of the marketplace lending model, "a small but growing component of the financial services industry that some banks are viewing as an opportunity to increase revenue." Defining the industry broadly "to include any practice of pairing borrowers and lenders through the use of an online platform without a traditional bank intermediary," the FDIC set forth some of the risks originating banks face in dealing with marketplace lenders, particularly those involving third-party arrangements.
Evaluating the risk involved in a marketplace lending relationship can be tricky given the early stages and evolving nature of the market and the variations depending on the borrower, the agency noted, cautioning that the need for such individualized risk identification "could lead to an incomplete risk analysis" or "gaps in bank management's planning and oversight." To protect themselves and limit supervisory concerns, the FDIC admonishes banks to "perform a thorough pre-analysis and risk assessment on each marketplace lending company with which it transacts business, whether acting as an institutional investor or a strategic partner." The agency's discussion follows an inquiry into the marketplace lending industry by the California Department of Business Oversight launched in December. To "assess the effectiveness and proper scope of our licensing and regulatory structure as it relates to these lenders," the state regulator sent a survey to 14 marketplace lenders to gather information about their business models and online platforms.
Given that the FDIC's mandate is to regulate licensed financial institutions, the agency's goal with the Supervisory Insights is to remind banks to not shortcut their due diligence responsibilities with respect to originating marketplace loans. There are only about a half dozen banks that originate on behalf of marketplace lenders, so their focus on the sector, especially with little risk posed to the deposit base by these loans because of the banks quick exit, is somewhat puzzling.
Detailed discussion
Banks considering an entry into the marketplace lending industry should consult the Winter 2015 edition of the Federal Deposit Insurance Corporation's (FDIC) Supervisory Insights newsletter. As marketplace lending has grown—from three lending companies in 2009 to 163 as of September 2015—the regulator provided an overview of the industry and offered financial institutions some tips on risk identification.
Broadly defining marketplace lending to include "any practice of pairing borrowers and lenders through the use of an online platform without a traditional bank intermediary," the FDIC explained that the process typically begins with a borrower submitting a loan application online where it is "assessed, graded, and assigned an interest rate" using the marketplace lending company's proprietary credit scoring tool. Factors generally considered include a borrower's credit score, income, and debt-to-income ratio.
Once the application process is complete, the loan request is advertised for retail investors to review and pledge funds. In addition, a large segment of the market is bought by institutional investors as whole loans. Once fully pledged, the marketplace lending company then originates and funds the loan through one of two frameworks: either lending the funds directly or partnering with a traditional bank to facilitate the loan transaction. Direct marketplace consumer lenders are typically required to be registered and licensed by state regulators, the FDIC noted, and facilitate all elements of the transaction. Alternatively, the bank-affiliated marketplace company hands over the reins to the bank once the loan application package is complete; the partner bank approves and funds the loan, holds the loan on its books for a few days and then sells it to the bank-affiliated marketplace company.
What risks do these models pose for banks?
"The marketplace lending business model depends largely on the willingness of investors to take on the credit risk of an unsecured consumer, small business owner, or other borrower," the FDIC said. But given the infancy of the market—and its existence during a period of low and steady interest rates—the current credit loss reports or loss-adjusted rates of return "may not provide an accurate picture of the risks associated with each marketplace lending product."
Adding to the calculation: The risk level varies with each marketplace lending company. "Given the credit model variations that exist, using a nonspecific approach to risk identification could lead to an incomplete risk analysis in the bank's marketplace investments or critical gaps in bank management's planning and oversight of third-party arrangements," the regulator explained. "As such, banks should perform a thorough pre-analysis and risk assessment on each marketplace lending company with which it transacts business, whether acting as an institutional investor or a strategic partner."
The FDIC highlighted several risks for all banks to consider, particularly third-party risk. Banks should review Financial Institution Letter 44-2008 on managing third-party risks, the agency suggested, and consider whether the proposed activities are consistent with the institution's overall business strategy and risk tolerance. This will require a "strong understanding" of the marketplace lending company's business model, regular monitoring, and contractual agreements protecting the bank from risk, among other factors.
Due diligence—with questions about what duties the bank relies on the marketplace lender to perform and who bears the primary responsibility for consumer compliance requirements—is essential, the agency added.
Other areas of risk: compliance risk, transaction risk, servicing risk, and liquidity risk. Banks should remember that they cannot assign the responsibility to comply with various fair lending laws and regulatory requirements—such as the Truth in Lending Act and the Equal Credit Opportunity Act—to the marketplace lending company. "Banks that partner with marketplace lending companies should exercise due diligence to ensure the marketplace loan underwriting and pricing policies and procedures are consistent with fair lending requirements," the FDIC said.
The potential for customer service problems or technology failures poses transaction risk while servicing risk exists given the pass-through nature of the marketplace notes, the agency wrote, especially if a marketplace lending company becomes insolvent. "At a minimum, banks that invest in marketplace loans should determine whether back-up servicing agreements are in place with an unaffiliated company before investment," the FDIC suggested, which could mitigate some risk of loss.
Liquidity risk is posed by the limited secondary market opportunities for marketplace loans, the agency noted, and a full risk analysis should also include considerations such as compliance with other state and federal requirements, including anti-money laundering laws. "The partner bank should evaluate the bank-affiliated marketplace company as it would any other customer or activity, and financial institutions investing in marketplace loans should exercise due diligence in evaluating appropriate compliance for any loan purchase," the FDIC emphasized.
FDIC examiners will assess how financial institutions manage third-party relationships and other investments with marketplace lenders by reviewing bank management's "record of and process for assessing, measuring, monitoring, and controlling the associated relationship and credit risks," the agency cautioned. "The depth of the examination review depends on the scope of the activity and the degree of risk associated with the activity and the relationship."
Marketplace lending offers an attractive source of revenue to banks, the agency recognized, but bank management must "look beyond the revenue stream" to determine whether the related risks align with the institution's business strategy. "[F]inancial institutions can manage the risks through proper risk identification, appropriate risk-management practices, and effective oversight," the FDIC concluded. "With the rapidly evolving landscape in marketplace lending, institutions should ascertain the degree of risk involved, remembering they cannot abrogate responsibility for complying with applicable rules and regulations."
To read the FDIC's Winter 2015 Supervisory Insights, click here.
