A study in the Finance and Economics Discussion Series (FEDS) by the Federal Reserve Board on consumer lending found that financial technology (FinTech) lenders are able to take advantage of federal preemptions from state rate ceilings to lend profitably to higher-risk consumers in states with low rate ceilings to compete in these markets.

The study is significant, as it provides support for banking regulators and consumer protection agencies that are subjecting FinTech lenders to regulatory scrutiny, despite the fact that the lenders are making loans to underserved populations. The loss of bank partnerships may jeopardize the viability of the business models of some FinTech lenders and access to credit for some consumers.

The study, which looks at the role of interest rate regulation of consumer credit and institutional risk segmentation in FinTech lenders' efforts to solicit new customers in the personal loan market, finds that strategic partnerships between FinTech companies and specialist banks target marginal-risk, near-prime, and low-prime consumers for credit card and other debt consolidation loans. The study also finds that FinTech-bank partnerships especially target marginal consumers in states with low interest rate ceilings.

The study confirms that what it refers to as mainstream banks largely avoid higher-risk consumers, and low-rate ceilings inhibit consumer finance company lending, which historically has been the major source of personal loans for higher-risk consumers and may compete with banks at the margin.

Federal regulations allowing a bank to charge rates permitted in its home state provide an opportunity for some banks located in high- or no-rate-ceiling states to partner with FinTech companies. Partner banks can legally charge rates that reflect the risk of loans, which enable them to originate loans to riskier consumers in low-rate states. When partnered with a bank, FinTech companies are able to access low-rate ceiling markets that other finance companies find unprofitable.

The study, "FinTech and Banks: Strategic Partnerships That Circumvent State Usury Laws," investigates the influence of interest rate regulation on credit availability for marginal consumers in personal loan markets. The study finds:

• FinTech-bank partnerships heavily targeted near-prime and low-prime consumers in states with restrictive interest rate ceilings
• The partnerships did not heavily solicit high-prime consumers, regardless of rate-ceiling regulation
• The partnerships appeared to have little interest in subprime consumers in high-rate states. However, FinTech-bank partnerships moderately solicited subprime consumers in states with low rate ceilings, likely because they faced relatively little competition in these states
• The study shows that finance companies heavily solicited subprime consumers in high-rate states. In contrast, banks showed little interest in consumers in any part of the risk spectrum other than the high-prime part. Notably, our data also allow us to confirm payday lenders' little-known but significant participation within the installment loan space

The study also discusses how state interest rate ceilings affect the structure of consumer credit markets, the research design and data used in the study, and empirical analysis and results.

Methodology

To determine the influence of interest rate regulation on credit availability in the personal loan market, the study's authors derived the loan solicitation data analyzed in the study from three sources from 2010-2019: (i) Mintel Comperemedia, which is a data set consisting of monthly unsecured personal loan solicitation offers, (ii) loan-level information from Prosper, and (iii) loan-level information from LendingClub. The Mintel data, as well as the data from Prosper and LendingClub, allowed the authors to compare the state-level share of mail volume to total mail volume over the period for each lender type. The authors then performed a comparative analysis of lenders and the state-level share of loan solicitation mail volume to total mail volume compared with the solicitations sent to different credit score categories (subprime, near prime, low price, and high prime) to determine how each state's interest rate cap influenced solicitation volume and the availability of credit.

The Power of Fintech-Bank Partnerships

When traditional lenders such as banks, thrifts, credit unions, and finance companies decelerated their consumer lending in the wake of the 2008 financial crisis, FinTechs emerged to fill the void left behind. FinTechs themselves do not typically have the authority to lend money to consumers, so they must either become licensed lenders at the state level or partner with an institution able to lend, such as a bank. Industry research cited in the study has found that FinTech borrowers tended to have lower credit scores than bank borrowers and that FinTech lenders often sought out risker consumers and small businesses in the credit market. Loans to riskier borrowers are typically made at higher interest rates.

Nearly every state, as well as Washington, DC, Puerto Rico, and other U.S. territories, have laws or regulations limiting interest that may be charged on a consumer loan. These interest rate limits vary by state, including high- or no-rate ceiling states and low-rate states. In 1978, the Supreme Court, in Marquette National Bank v. First Omaha Service Corporation, ruled that national banks could charge interest rates permitted by the lending bank's home state regardless of the rate permitted by the borrower's state of residence.

State-chartered banks have similar authority under the Depository Institutions Deregulation and Monetary Control Act (DIDA), which allows state banks to charge interest at the rate allowed by the laws of the state, territory, or district where the bank is located. States are permitted to opt out of DIDA, and as we previously detailed, Colorado recently passed a law opting out of DIDA after previously opting in, joining a handful of other states that opted out or rescinded their opt-in to Marquette's interest rate exportation regime. As such, states like Utah and New Jersey—which have no limit on the interest that may be charged on consumer loans—are attractive to banks and potential banks as a "home state" because of the minimal limits on consumer loan interest rates.

Given this authority, instead of becoming licensed as a lender, the study notes many FinTechs have sought partnerships with state-chartered or national banks so that they can participate in the consumer loan market and take advantage of the bank's home state for interest rate regulation. The study outlines that typically these relationships are structured as follows:

• The FinTech will solicit potential customers for a consumer loan
• The FinTech may take the application or other data to allow the bank to underwrite the loan
• The bank will underwrite and originate the loan to the consumer, thereby making the bank the "true lender"
• The bank will hold the loan on its books for a period of days to months
• The FinTech will repurchase the loan from the partner bank and typically sell the loan in a securitized offering

Under a long-standing valid-when-made doctrine, a transferee of a loan (i.e., the FinTech) has the right to enforce the loan on the same terms as those that had been available to the transferor (i.e., the bank) when the loan was made, although state and federal regulators have been critical of the doctrine and continue to scrutinize the validity of the valid-when-made doctrine.

Challenges for FinTech-Bank Partnerships

As highlighted in the study, a significant challenge to the valid-when-made doctrine came in 2015 when the U.S. Court of Appeals for the Second Circuit overturned a lower court ruling and decided that nonbank assignees of loans were not entitled to protection from state usury limits. Madden v. Midland Funding, LLC, 786 F.3d 246 (2nd Cir. 2015). While that decision applied only to loans originated in states in the Second Circuit (including Connecticut, New York, and Vermont), the study concludes that its effects have rippled across the FinTech landscape. According to the study, FinTech companies partnering with banks considerably reduced solicitation for personal loans in Second Circuit states following the Madden decision, especially for high-risk consumers. Even beyond the Second Circuit states, the study found, loan solicitations (based on mail volume) in other states remained flat, potentially because of uncertainty caused by the Madden ruling. The study noted other, wider effects, including the capping of interest rates according to usury limits; the exclusion of loans to New York, Connecticut, and Vermont residents from securitizations pools; and restructuring of bank partner relationships so that the bank retained an interest on all of the loans. With that said, the study does not reflect the impact of the 2020 OCC and FDIC rulemakings codifying "valid when made" for loans by federal and state banks.

Federal courts are not the only source of restrictions on bank partnership models, as both federal regulators and states have taken action to restrict the operations of bank partnerships. At the federal level, prudential banking regulators have released guidance and acted against banks engaged in bank partnerships. For example, as we discussed here, the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued final guidance on managing risks associated with third-party relationships, including bank partnerships with non-bank FinTechs. In 2022, the OCC entered into an agreement with Blue Ridge Bank, N.A. requiring Blue Ridge Bank to make reforms to its compliance practices relative to third-party relationships.

At the state level, there has been a recent uptick in state legislation requiring licensure as a consumer loan company when participating in bank partnerships. For example, in June of 2023, Nebraska passed Legislative Bill 92, which, among other things, amended the licensing requirements of the Nebraska Installment Loan Act to include "any person that is not a financial institution who, at or after the time a loan is made by a financial institution, markets, owns in whole or in part, holds, acquires, services, or otherwise participates in such loan." This expands the licensing requirement to include marketers, servicers, and purchasers of bank loans, participation interests, or other limited interest in bank-partnership loans. Similarly, states such as New Mexico, Connecticut, and Minnesota have all recently passed laws that generally provide that a bank's nonbank partner is the actual lender when the nonbank holds or acquires the predominant economic interest in the loans, or markets, arranges, or facilitates the loans, and/or provides that the loan is deemed to be made by the nonbank if "the totality of the circumstances" indicates that the nonbank is the lender and the transaction is structured to evade the requirements of the statute.

What's to Come

Given the speed and pace at which states have passed legislation concerning participants in bank partnerships, it is likely that this trend will continue throughout 2023 and beyond. Similarly, federal banking agencies are continuing to scrutinize bank partnerships and recently released guidance concerning managing risks in third-party relationships.

For FinTechs, monitoring state laws requiring licensure to either originate or participate in the origination of consumer loans is vital to ensuring that appropriate licensure is sought if additional states expand their consumer loan licensing statutes to include those that participate in consumer loan origination or take ownership of consumer loans after origination. Furthermore, building the necessary functions for compliance with the law and any requirements imposed by a bank partner is important to avoid regulatory scrutiny or enforcement.

For bank partners, the importance of due diligence of third-party partners and having a third-party risk-management plan that is appropriate for the size and scope of the third-party relationship cannot be overstated. In the case of relationships with FinTechs in the consumer loan space, bank partners should confirm, among other things, that their FinTech partners are appropriately licensed and have their own compliance frameworks, in order to be certain of their compliance with the law and their own regulators. In light of the banking agencies' recently released guidance and the OCC's action against Blue Ridge Bank in 2022, it is clear that federal banking agencies are scrutinizing third-party relationships and may act if a bank's risk management compliance is not properly tailored to mitigate the risks of the relationship.