On May 10, the U.S. Department of the Treasury (hereafter, Department or Treasury) released a report on “Opportunities and Challenges in Online Marketplace Lending.” The result of Treasury’s July 20, 2015 Request for Information (RFI) on Expanding Access to Credit through Online Marketplace Lending, the report summarizes the Department’s understanding of the online marketplace lending industry, including the potential benefits and risks of the growing industry in relation to consumers’ financial needs. Treasury’s key observations and findings are discussed in sections three through six of the report – Background and Definitions; Treasury Research Efforts and Themes from (RFI) Responses; Recommendations; Looking Forward.
Background and Definitions
The report provides a high-level overview of the two primary business models in online marketplace lending: (i) direct lenders originating loans to hold in their own portfolios (or balance sheet lenders); and (ii) platform lenders that partner with an issuing depository institution to originate loans, subsequently purchasing the loans and reselling them to whole-loan investors or issuing securities tied to the performance of the loans. Commenting on the various types of consumer loans offered through marketplace lending, the report identifies the unsecured consumer credit market (debt consolidation, credit card repayment, and home improvement), small business credit market, and student loan market as constituting the majority of the industry’s business. The report also notes that the industry is moving into the mortgage lending and auto loan markets. According to the report, while both direct lenders and platform lenders have altered their frameworks to allow for “flexibility in varying economic environments,” neither has demonstrated an ability to perform well in a less than favorable economic environment: “[o]nline marketplace lenders have demonstrated their ability to improve operational efficiencies, but neither the durability of technology-driven operations and credit underwriting, nor the sustainability of investor demand for loans, have yet been tested during a downturn in the credit cycle.”
Treasury Research Efforts and Themes from RFI Responses
The report summarizes approximately 100 industry responses to the RFI. According to Treasury, the overarching topics that emerged from the comments included:
- Data and Modeling Techniques for Underwriting: While the industry’s use of data as an underwriting tool to provide loans in targeted market areas expedites credit assessment and reduces cost, the report suggests that it also poses disparate impact risk in credit outcomes and could lead to fair lending violations. Many commenters highlighted the efficiency benefits of automated data sources, while others expressed concern for the lack of transparency when using “big data.”
- Access to Credit: Industry stakeholders maintain that online marketplace lending is expanding access to credit by lending to borrowers who otherwise might not qualify for loans from traditional financial institutions.
- Operational Challenges: According to commenters, a gap in lenders’ servicing and collection capabilities exist. In addition to concern that new underwriting models have not been tested through a full credit cycle, consumer advocates expressed concern for the industry’s reliance on servicing and collections firms: “[w]here depository institutions have tended [to] perform most functions internally, many online marketplace lenders are choosing to specialize in certain core functions while outsourcing other services.” Since new underwriting models and underlying operations of the industry have not been tested in deteriorated credit conditions, commenters’ main concern in relation to the “heavy” reliance on outsourcing services to collections and servicing firms lies in the possibility of a rise in delinquencies and defaults.
- Consumer Protection: RFI commenters addressed a need for “uniform consumer protections across financial institutions and online marketplace lenders,” with many consumer advocates arguing for enhanced safeguards for small business borrowers: “[s]mall business loans do not currently operate under all of the same consumer protection laws and regulations as personal loans, but may receive protection only under contract law or the enforcement of fair lending laws under ECOA. Consumer advocates argued that many small business borrowers should be treated as consumers.”
- Transparency: Most commenters agreed that greater transparency in disclosure forms would benefit industry participants, borrowers and investors alike.
- Secondary Market Activity: Commenters acknowledged that the secondary market for whole loans is underdeveloped, noting that although trading platforms for online marketplace securities have emerged, they’re not widely used. Generally, commenters agreed that the industry would benefit from a transparent and “well-functioning securitization market with active repeat issuance.”
- Regulation: Commenters’ views regarding the regulatory regime surrounding the industry varied. Some argued for a uniform regulatory regime, others recommended an ongoing interagency working group, and several argued that existing regulations sufficiently address industry risk. A need for greater regulatory clarity was expressed in many comments, with commenters drawing attention to the following areas: (i) consumer protection; (ii) small business protection; (iii) cybersecurity and fraud; (iv) true lender designation in the platform business model; (v) BSA/AML requirements; and (vi) risk retention.
Based on its understanding of the marketplace lending industry and review of responses to the RFI, Treasury makes the following policy recommendations in the report: (i) support greater small business borrower protections and effective oversight; (ii) adopt industry servicing standards that ensure sound borrower experience from customer acquisition through collections in the event a loan becomes delinquent; (iii) promote a transparent marketplace by, among other things, creating a “private sector driven registry for tracking data on transactions, including the issuance of notes and securitizations, and loan-level performance”; (iv) expand access to credit through sound partnerships with traditional financial institutions and Community Development Financial Institutions; (v) support the expansion of safe and affordable credit through government held data by promoting the use of smart disclosures (the release of information in standard machine readable formats that third-party software can easily process) and data verification sources; and (vi) facilitate interagency coordination by creating a standing working group to include the Treasury, CFPB, FDIC, Federal Reserve, FTC, OCC, Small Business Administration, and SEC that would, among other things, identify areas where additional regulatory clarity could benefit consumers.
In its final section, the report addresses trends and developments that Treasury believes “should be closely watched.” Regarding evolving credit scoring models, the report expressed concern on behalf of consumer advocates that increased automation and accuracy of credit scoring may “create a vicious cycle where those already disadvantaged will pay more for credit, and therefore be more likely to become financially fragile and default, and the cycle will repeat itself.” Referencing an increase in delinquency rates from January to December 2015, as well as an increase in charge off rates from October 2015 to December 2015, Treasury further stresses the need to monitor how the industry tests and adapts models in an unfavorable credit environment. Additional areas to monitor highlighted in the final section include: (i) the investment community, noting that as securitization activity increases, “[p]rudent loan underwriting, securitization transaction pricing, and robust governance and disclosures are necessary to ensure market soundness”; (ii) cybersecurity, encouraging financial sector firms to develop sufficient baseline protections and best practices to mitigate the risk of cyber incidents and to protect consumers; (iii) Bank Secrecy Act requirements, emphasizing that FinCEN will continue to monitor the industry for money laundering and terrorist financing risks; and (iv) mortgage and auto loan markets, with Treasury continuing to monitor the origination volumes and loan performance as these sectors within the industry develop.