On May 10, 2016, the U.S. Department of the Treasury released its highly anticipated white paper on online marketplace lending. Treasury's recommendations will likely be influential in U.S. regulation of this marketplace for many years to come.
Few areas of financial technology have garnered more attention of late than marketplace lending: the process of borrowing and lending money online from Web-based portals. With the fast-growing industry—over $50 billion worldwide in 2015—Treasury sent a request for information (RFI), "Public Input on Expanding Access to Credit through Online Marketplace Lending," to members of the community and the general public last summer. Many stakeholders in the industry, including Manatt, submitted comment letters.
Treasury's white paper, which follows that RFI, (1) establishes an overview of the evolving market landscape, reviews stakeholder opinions, and provides policy recommendations; (2) acknowledges the benefits and risks associated with online marketplace lending; and (3) highlights certain best practices applicable both to established and emerging market participants. In preparing the report, Treasury did not operate in a vacuum. In addition to extensive public input from and research on participants, Treasury likewise consulted with staff from other agencies, including the Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve System (FRB), Federal Trade Commission (FTC), Office of Comptroller of the Currency (OCC), Small Business Administration (SBA), and Securities and Exchange Commission (SEC).
Common Themes Emerge
According to Treasury, the following common themes emerged from the RFI process:
- Use of Data and Modeling Techniques for Underwriting Is an Innovation and a Risk: RFI commenters agreed, Treasury claims, that the use of data for credit underwriting is a core element of online marketplace lending, and one of the sources of innovation that holds the most promise and risk. While data-driven algorithms may expedite credit assessments and reduce costs, Treasury claims they also carry the risk of disparate impact in credit outcomes and the potential for fair lending violations. Treasury argues that applicants do not have the opportunity to check and correct data potentially being used in underwriting decisions.
- There Is Opportunity to Expand Access to Credit: RFI responses, says Treasury, suggested that online marketplace lending is expanding access to credit in some segments by providing loans to certain borrowers who might not otherwise have received capital. Although the majority of consumer loans are being originated for debt consolidation purposes, small business loans are being originated to business owners for general working capital and expansion needs. Distribution partnerships between online marketplace lenders and traditional lenders may present an opportunity to leverage technology to expand access to credit further into underserved markets.
- New Credit Models and Operations Remain Untested: New business models and underwriting tools have been developed in a period of very low interest rates, declining unemployment, and strong overall credit conditions. However, this industry remains untested through a complete credit cycle, Treasury says. Higher charge-off and delinquency rates for recent vintage consumer loans may augur increased concern if and when credit conditions deteriorate.
- Small Business Borrowers Will Likely Require Enhanced Safeguards: Treasury says commenters drew attention to uneven protections and regulations currently in place for small business borrowers. They also note that RFI commenters "across the stakeholder spectrum" argued small business borrowers should receive enhanced protections.
- Greater Transparency Can Benefit Borrowers and Investors: Treasury claims that responses strongly supported and agreed on the need for greater transparency for all market participants. Suggested areas for greater transparency include pricing terms for borrowers and standardized loan-level data for investors.
- Secondary Market for Loans Is Undeveloped: Although loan originations are growing at high rates, the secondary market for whole loans originated by online marketplace lenders is limited, says Treasury. RFI commenters agreed, Treasury asserts, that active growth of a securitization market will require transparency and significant repeat issuances.
- Regulatory Clarity Can Benefit the Market: Treasury acknowledges that commenters had "diverse" views of the role government could play in the market, suggesting that many RFI commenters were opposed to government interference in the marketplace. However, a large number argued that regulators could provide additional clarity around the roles and requirements for the various participants.
As more fully detailed in the report, and based on the RFI responses and other input, Treasury now recommends that government regulators and participants:
1. Support more robust small business borrower protections and effective oversight
Treasury notes that banks and online marketplace lenders are generally subject to the same statutory requirements when originating small business loans, but depository institutions are subject to a higher degree of oversight by the prudential regulators. Treasury argues that effective oversight could enable greater transparency in small business online marketplace lending that could lead to better outcomes for borrowers. Through "efforts like the Small Business Borrowers' Bill of Rights, the private sector has started to organize support from online marketplace lenders for transparent pricing and terms, non-abusive products, responsible underwriting, fair treatment from brokers, inclusive credit access, and fair collection practices, suggesting this can be done without adding undue burden or cost to this emerging industry."
2. Ensure sound borrower experience and back-end operations
Treasury acknowledges that servicing challenges are "currently limited due to the favorable credit climate and the fact that most online marketplace lenders collect loan payments through Automated Clearing House (ACH)." When loans become delinquent, however, servicing is then typically transferred to collection agencies. Treasury is concerned that in "a less favorable credit climate, it is unclear if the current servicing infrastructure would respond adequately to increased delinquencies."
3. Promote a transparent marketplace for borrowers and investors
To promote transparency, Treasury recommends: (1) Standardized representations, warranties, and enforcement mechanisms; (2) Consistent reporting standards for loan origination data and ongoing portfolio performance; (3) Loan securitization performance transparency; and (4) Consistent market-driven pricing methodology standards.
4. Expand access to credit through partnerships that ensure safe and affordable credit
Treasury is concerned that online marketplace lenders are mostly serving just the prime and near-prime consumer borrowing community: "For technology to truly expand access to underserved markets, more must be done to serve borrowers who are creditworthy, but may not be scoreable under traditional credit scoring models. These borrowers include so-called 'no file' or 'thin file' consumers, or small businesses with less than three years of operations."
5. Support the expansion of safe and affordable credit through access to government-held data
Treasury notes that while online marketplace lenders currently do not have access to comprehensive data sources to conduct capacity verifications with the borrower in real time, the federal government's My Data initiative will make it easier for federal agencies to allow individuals to access their personal data held by government agencies. Treasury's white paper recommends automating the IRS Income Verification Express Services (IVES) with a data-sharing Application Programming Interface (API). This API would reduce operational costs, reduce paperwork and waiting period burdens on borrowers, facilitate compliance with consumer protection rules regarding the verification of borrowers' ability to pay, and potentially expand access to credit.
6. Facilitate interagency coordination through the creation of a standing working group for online marketplace lending
Treasury recommends creation of an interagency working group and suggests that it (1) identify and promote awareness of regulations that apply to online marketplace lending, (2) support responsible innovation, (3) examine the impact of nontraditional data on credit scoring models, and (4) monitor risk throughout the credit cycle.
Overall, there are few surprises in Treasury's white paper, as stakeholders continue to negotiate their respective positions. Treasury's acknowledgment that the system has largely operated for the benefit of borrowers, lenders and other participants is an important step in providing further legitimacy to various online marketplace lending models.