Strange Bedfellows: Fintech-Bank Partnerships Hold Promise but Pose Regulatory Perils

Financial technology firms, or “fintechs,” have made a major impact on the consumer finance market in the US.? Touting arrangements known as “Banking as a Service,” these entities have partnered with banks to offer online lending and payment services and promise to provide financial services in new and underserved markets.? Among these is the market for consumer credit.?

The Federal Reserve has reported that consumer credit, at $3.6 trillion, stands at an all-time high in the US.? Yet smaller borrowers, particularly those with low incomes and low credit scores, can still find it difficult to obtain credit.? Fintech-bank partnerships have sought to fill this gap.? Banking regulators, while sensitive to the needs of low income consumers, have also expressed skepticism and concern about these arrangements.? A recent study by the Federal Reserve found that while fintech lending partnerships do offer credit to low income borrowers, their impact on the market is uneven and uncertain.

Fintech-bank partnerships in the consumer lending market arose primarily in response to regulatory constraints.? State usury laws traditionally limit the amount of interest that banks could charge on a consumer loan.? Many states set different, higher limits for state-licensed and regulated consumer finance companies.? In 1978, the Supreme Court ruled, in the Marquette Bank case, that a national bank could lend at the maximum rate set by the state where it was located, regardless of the residence of the borrower.? This led to an explosion of national credit card lending, as banks created credit card banks in states with high, or no limits on interest rates.

The promise of higher rates was still not enough to tempt most banks to enter the market for unsecured personal loans to low income borrowers. Because the cost of loan production does not vary greatly depending on the size of the loan, smaller loans are less profitable for banks.? And many banks simply did not want to assume the risks that come with lending to borrowers with lower incomes and lower credit scores. The combination of a general contraction of lending activity following the 2008 financial crisis and the rise of internet-based commerce made it mutually beneficial for banks to team with fintech lenders to serve this market.?

Fintech-bank partnerships could offer loans at the higher interest rates permitted to national banks and, so long as the bank itself originated and underwrote the loan, could avoid state licensing and regulatory restrictions. The two largest bank partners of fintech lenders are a state-chartered, Utah-based industrial loan company (which is not subject to any interest rate limits) and a nationally chartered bank in New Jersey (which has no interest rate limits).?

In the typical arrangement, the fintech lender solicits the loan and takes the application through an online platform.? The bank, acting as the “true lender, ” then originates and underwrites the loan, often using the fintech’s proprietary algorithm to supplement traditional underwriting methods.? The resulting loan is then sold back to the fintech company for resale or securitization, although the bank may retain a portion of the loans produced on its own balance sheet.? Both entities profit by assessing processing fees.

These partnerships have had an impact both on the consumer lending market and the regulatory landscape.? The Federal Reserve’s “Finance and Economics Discussion Series (FEDS)” recently published a paper that sought to identify those portions of the market most frequently targeted by fintech lenders. ??The study analyzed data on mail solicitations to borrowers, the characteristics of the loans made by fintechs, and the credit scores of the borrowers.? The type of loan most frequently marketed by fintech lenders is an unsecured, personal consolidation loan. These loans are marketed to the consumers who are often most likely to be considered marginal by banks, either because the loans are too small to be profitable for the bank or the borrower is considered too risky.? The loans tend to be offered in areas with larger minority populations and a lower density of bank branches.

The study found that the type of borrowers targeted by fintech lenders varied depending on the interest rate limits in the state where the borrower resided.? In states that allowed high interest rates, fintech lenders generally solicited near-prime and low-prime, but not subprime customers.? In these states, finance companies were more likely to lend to subprime customers and fintechs were less likely to compete.? But in states with low interest rate caps, the fintech lenders also solicited subprime customers, taking advantage of their ability to export a higher interest rate than the local finance company was permitted to charge.? Fintech-bank partnerships solicited virtually no loans from high-prime (or more creditworthy) customers. The study concluded that, while fintech lenders did not lend to all types of low income consumers in all states, they were able to lend profitably to higher-risk consumers in states with low interest rate ceilings.

Federal bank regulators have made bank third party risk management, including management of fintech relationships, a priority in recent years.? The three federal banking regulators jointly issued guidance on management of risks associated with third party relationships earlier this year, and have made this a priority subject of examination.? The Office of the Comptroller of the Currency required Blue Ridge Bank to enter into a formal written agreement in 2022 that imposed multiple requirements aimed at improving the bank’s compliance, risk assessment and oversight over its fintech partners, with a focus on Bank Secrecy Act (BSA) and Anti-Money Laundering (AML) compliance.? This year, the New York State Department of Financial Services and the Federal Reserve issued cease and desist orders and civil money penalties of almost $30 million against Metropolitan Commercial Bank as a result of its failure to detect and police a scheme operated by a fintech partner.? The partner allegedly opened tens of thousands of fraudulent accounts as part of a scheme to divert fraudulently received unemployment benefits from the State of New York.

Some states have also taken some actions designed to prevent fintech partnerships from exporting interest rates on consumer loans.? These have taken the form of both expanded state licensing requirements that are designed to include fintechs, and redefining the “true lender” doctrine to provide that where the fintech company takes the dominant role in soliciting, administering and reselling the loan, the originating bank is no longer entitled to preemption of state interest rate limits. These regulatory actions demonstrate the perils of fintech partnerships for banks.?

Fintech lending can serve a portion of the consumer lending market that has traditionally been neglected by traditional financial institutions.? As the “true lenders” on fintech loans, however, banks must ensure that the fintech partner adheres to underwriting, compliance, and BSA/AML standards in the same way as if the bank itself was soliciting the loan.? Regulators will be particularly skeptical of banks whose fintech partnerships comprise a substantial part of their business, fearing that they are simply “renting their charter” to a third party. The fintech lending business model, in which banks originate and rapidly sell large volumes of loans through third parties, contains echoes of the residential mortgage securitization activities that created massive systemic risk during the financial crisis.? Banks, their fintech partners, regulators, and the public will all benefit by ensuring that those mistakes are not repeated.

The FEDS study on consumer lending by fintech-bank partnerships is available at https://www.federalreserve.gov/econres/feds/files/2023056pap.pdf

The interagency guidance on third party relationship risk management for financial institutions is available at https://www.federalregister.gov/documents/2023/06/09/2023-12340/interagency-guidance-on-third-party-relationships-risk-management

?My podcast, “Risk Management for Financial Institutions - How Banks Stay Safe and Sound,” is available at https://youtu.be/2kNWCLQp678.

?Fred Egler is an independent consultant who advises on operational risk issues at financial institutions, including banking, securities and insurance.? He can be reached at [email protected].