New Questions, Old Answers – As Fintech Lending to Consumers Soars, States Revive Usury Laws

Fintechs have disrupted the consumer lending industry, offering loans to many borrowers ignored by banks.? A 2023 Fed study estimated that fintechs had $50 billion in loans outstanding to consumers.? Several of these enterprises, such as SoFi, Avant, and Affirm, have attracted in excess of $1 billion in investment. Relying on a marketing strategy that stresses how different they are from banks, most fintech lenders nonetheless rely on relationships with those same banks to support a key element of their business model – the ability to charge unregulated interest rates to consumers.

As we discussed in a previous newsletter(“Strange Bedfellows: Fintech-Bank Partnerships Hold Promise But Pose Regulatory Perils,” available here), national banks are permitted to issue loans at the interest rate allowed by their home state to borrowers anywhere in the US.? Large credit card issuers use this rule to issue credit cards from states with very high or no limits on interest rates.? But national banks have cooled on fintech partnerships, in large part because of hostility from the Office of the Comptroller of the Currency (OCC), which regulates national banks.

State-chartered banks, by contrast, have enthusiastically embraced fintechs.? A 1980 federal statute, DIDMCA ( the “Depository Institutions Deregulation and Monetary Control Act”) gives state-chartered banks the same ability to export interest rates as national banks operating in their states.? DIDMCA allowed states to opt out of this rule.? Fearing a competitive disadvantage between their home state banks and national banks, very few states took advantage of this option.?

State banks also relied on the “valid when made rule,” which provides that if a loan was valid under state usury laws when and where the bank made it, a subsequent transfer of the loan – whether to another bank or to a fintech – could not subject it to state interest rate regulation. Nonbank lenders could use their bank partnerships to rely on DIDMCA and “valid when made” and take advantage of? the same exemption from interest rate regulations enjoyed by the banks.? When fintech lenders created new products that were easily accessible online, ?lending volumes soared.? With some fintech lenders charging interest rates in excess of 100%, consumer protection advocates saw exploitation and began to seek relief.

Critics see many fintech “partnerships” with banks as little more than “rent-a-charter” schemes.? Fintechs market the loans and, once the bank makes them, purchase and service them.? The bank’s only involvement is in underwriting and origination of the loan.? Critics argue that banks, knowing that these loans will be purchased by the fintechs, do not exercise independent judgment or authority in making credit decisions.?

The functional regulator for most state-chartered banks, the FDIC, has recently issued enforcement actions against some banks engaged in fintech lending partnerships.? But these have tended to focus on the risk of the arrangement to the bank, and not its impact on consumers.?

Critics began to enjoy some successes when in 2015, the United States Court of Appeals for the Second Circuit decided Madden v. Midland Funding.? The court held that “valid when made” did not apply when the purchaser of the loan was not a bank.? The case applied only to loans within the court’s jurisdiction (three states in the Northeast) and was quickly met with pronouncements from the OCC and the FDIC reaffirming the “valid when made” rule.? But the decision emboldened critics, who began chipping away at longstanding limits on the use of state usury statutes to regulate interest rates.

Since Madden, several states have either passed or introduced statutes that would opt out of DIDMCA and limit or eliminate the “valid when made” rule.? This would, at least in theory, subject loans to residents of these states to state usury law interest rate restrictions.? But the banks and their fintech partners are fighting back.? Banking trade groups have sued in federal court in Colorado to invalidate the opt-out statute, arguing that, among other things, it would interfere with interstate commerce, restrict competition and reduce consumer choice.

Opting out of DIDMCA may not be a panacea for high interest rates.? The Colorado statute and others under consideration apply to loans made in those states.? But DIDMCA lists other factors, in a provision that is not subject to opt-out, that specify where a loan is considered to be made.? These rules could be interpreted to allow out of state banks to continue to enjoy the DIDMCA exemption in opt-out states so long as they have no physical presence in the state.

DIDMCA opt-out statutes could thus be subject to a somewhat self-defeating interpretation that they apply only to banks in their home states.? This would put home state banks at a competitive disadvantage with out of state lenders – one of the main arguments by opponents of these statutes, which are likely to be the subject of lengthy litigation.

Other states have adopted or proposed so-called “true lender” statutes designed to alter or repeal the “valid when made” rule.? One such proposed statute, in the District of Columbia, provides that any entity that has the “whole, predominant, or partial economic interest, risk or reward” in the loan is to be considered the true lender.? Others provide that this determination is to be made based on the “totality of the circumstances” of the transaction, as opposed to looking solely to the status of the parties as reflected in their contractual terms.

These “true lender” statutes have the potential to have a greater and more immediate impact on fintech partnerships.? If upheld by the courts, the statutes could treat fintech lenders, and not the banks, as the “true lender,” and thus deny them the interest rate exemptions enjoyed only by banks.? They would also call into question the ability of nonbank purchasers of loans from national banks to rely on the “valid when made” rule as a defense to claims of usury.? Such an interpretation is certain to be resisted by national banks and their regulators and, like the DIDMCA opt-out bills, faces a series of lengthy court battles.

The legal thicket created by the reaction of some states to fintech lending follows a familiar pattern. The story of consumer finance in the US over the last 50 years has been one of rapid acceptance of new products – 30 year mortgages, credit cards, money market funds, discount brokerages – that previously did not exist or were available to only a privileged few. In each case, new techniques and players enter a field with new products.? These products are designed for a market – in this case, consumer credit – that the incumbents have been slow or unwilling to serve.? Congress and federal regulators fail to keep pace with these new entrants and their products, either because of regulatory inertia or opposition from those who believe that new regulation would stifle competition and limit consumer choice.? In the resulting regulatory vacuum, others – in this case, consumer groups and states — use litigation and state legislation as a substitute for federal rules.? Ultimately, the new products survive, with varying degrees of restrictions.

Prohibitions against usury are hundreds of years old (Shakespeare’s “The Merchant of Venice” turns on Shylock’s demand for a “pound of flesh”).? Every state has a statute prohibiting usury.? Yet inherent in these rules is a conflict between the market forces that animate the supply of and demand for credit and moral qualms about interest rates that seem exploitative.? Something about 100% interest seems fundamentally unfair, until that is your only option for credit.? Fintech lenders will not completely resolve these tensions. But with appropriate regulation, they offer new opportunities for a market – consumer credit – that has long been underserved by traditional lenders.

If you’re interested in knowing whether a DIDMCA opt-out or “true lender” bill is pending in your state, many law firms have posted summaries of the status of these bills.?? A recent, very complete one is available at https://www.jdsupra.com/legalnews/welcome-to-2024-didmca-opt-out-and-true-5737765/.

The Federal Reserve’s study of fintech penetration of the consumer credit market is available at https://www.federalreserve.gov/econres/notes/feds-notes/fintech-issued-personal-loans-in-the-us-20230830.html.

My podcasts, “Risk Management for Financial Institutions - How Banks Stay Safe and Sound” and ”Not Too Boring to Fail, Part II” – How changes in investment strategies affect the life insurance and annuity industry,” are available at ?https://www.youtube.com/watch?v=2kNWCLQp678 and https://www.youtube.com/watch?v=zeD1txRMxbM)

?

Fred Egler is an independent consultant who advises on operational risk issues at financial institutions, including banking, securities and insurance. He is also a member of the National Roster of Arbitrators of the American Arbitration Association.? He can be reached at [email protected].

?

?

?

?

?