The FDIC’s new requirements will substantially increase the costs imposed on banks that wish to purchase marketplace loans.
On November 6, the Federal Deposit Insurance Corporation (FDIC) issued Financial Institution Letter FIL-49-2015, warning banks about the risks of purchasing and participating in loans originated by non-bank third parties, like marketplace lenders.
The day before, Rae Ann Miller, Associate Director of Risk Management Supervision, spoke to a meeting of the FDIC's Advisory Committee on Community Banking on the topic of emerging trends and risks. She expressed concern about marketplace lending and the risk it posed to insured depository institutions. Specifically, she articulated worry about the stability of funding sources, the transparency of disclosures, the high cost of credit to small business, the systemic risk presented by high-cost small business lending, and the limitations of “algorithmic lending,” particularly in times of stress.
What Does FIL-49-2015 Do?
The Financial Institution Letter (FIL) addresses the underwriting and credit risks associated with purchased loans and loan participations from third parties, and it reminds FDIC-supervised institutions of the importance of underwriting and administering purchased credits as if the loans were originated by them. This means that banks must perform a complete analysis of collateral and credit risk of each loan or participation and must have a complete understanding of the borrower's market and industry. Additionally, "this assessment and determination should not be contracted out to a third party." Banks also must conduct an independent analysis and validation of any credit models used by third-party originators. Finally, any third-party arrangements to facilitate the purchase of loans and loan participations must be managed by an effective third-party risk management process.
The FDIC points to specific risks of purchasing and participating in loans originated by non-bank third parties, particularly loans that are unsecured, are made to out-of-territory borrowers, are to borrowers in industries unfamiliar to the bank, or are underwritten using proprietary models that limit the ability of the bank to assess underwriting quality.
The FDIC notes that it has seen several instances where "it is evident that financial institutions have not thoroughly analyzed the potential risks arising from third-party arrangements."
Finally, the FDIC has added additional burdens for banks as they are now required to obtain necessary board and committee approvals for purchases of loans or participations in loans, as well as when the banks intend to enter into a third-party arrangement to purchase or participate in loans.
Importantly, these new requirements, which will be overseen by FDIC bank examiners, will have no impact on marketplace platforms, such as Lending Club and Prosper, that purchase loans from banks that do the origination. The FIL only impacts banks that purchase loans from marketplace lenders.
As set forth in this FIL, the requirements that banks must meet to purchase loans from marketplace lending platforms are now substantial. The requirements regarding purchasing loans from areas of the country outside of where the bank operates, having to understand industries not served by the bank, and understanding proprietary underwriting models will no doubt substantially increase the costs imposed, particularly on smaller banks that wish to purchase marketplace loans.
Although the number of loans being purchased by banks that are originated by marketplace lenders is not readily available, it appears that many lenders view loans originated by marketplace lenders as attractive for a number of reasons, including the elimination of origination expenses, the ability to obtain an attractive asset, and the difficulty that banks have in efficiently making smaller loans. These new requirements will undermine the ability of banks to purchase marketplace loans since they now come with increased costs.
This FIL replaced FIL-38-2012, FDIC Advisory on Effective Credit Risk Management Practices for Purchased Loan Participations. In doing so, the new FIL added additional responsibilities for banks, including (1) a focus on effective third-party risk management processes, (2) the addition of leveraged and unsecured loans as the types of loans subject to risk management functions and (3) the need to obtain necessary board and committee approvals for purchasing a loan or participation or entering into a third-party arrangement to purchase or participate in loans.
Ironically, given the Treasury Department’s recent request for information, which supported marketplace lending and focused in part on how the federal government could be supportive of the innovations in marketplace lending, we now have a federal banking agency that is creating roadblocks to having banks participate in this dynamic and rapidly growing space.