Federal Reserve Governor Lael Brainard Speaks About Alternative Lenders
Federal Reserve Governor Lael Brainard gave the September 30th closing keynote address at the Community Banking in the 21st Century 2015 Conference and here are some of the highlights of what she had to say about online lenders and merchant cash advances:
The data that are available suggest that the various types of online alternative lenders have captured a small but rapidly growing share of lending since the financial crisis. In aggregate, the outstanding portfolio balances of these lenders have doubled every year since the mid-2000s. It is estimated that online alternative lenders originated $12 billion in 2014, with unsecured consumer loans representing $7 billion and small business loans accounting for approximately $5 billion.13 While this amount represents only a small fraction of U.S. unsecured consumer and small business lending overall, the rate of growth is notable.
Although rates vary by platform and borrower characteristics, when taking into account origination fees and repayment periods, the average annual cost of borrowing, or APR, associated with loans and credit products offered by online alternative small business lenders tend to be higher than those associated with traditional bank products. Reports suggest that some borrowers are willing to pay a higher price in exchange for an easy application process, a quick decision, and rapid availability of funds.
While some see online alternative lenders as a disruptive threat to traditional lenders, banks increasingly are finding ways to partner with online alternative lenders, including through loan purchases and referral agreements. Loan purchases by community banks of loans originated by online alternative lenders have been focused on unsecured consumer debt. As the percentage of unsecured consumer debt outstanding held by community banks has been declining in recent years, several banks have partnered with online alternative lenders to grow and diversify their portfolios of unsecured consumer debt.
In contrast to the consumer loan activity, the small business partnerships that have developed so far are largely fee-based referral partnerships. In these partnerships, banks refer to online alternative lenders some of their small business customers who are usually seeking loan amounts that the referring banks may see as too costly to underwrite and service, particularly in the size range below $100,000.
Across the Federal Reserve System, we are actively following developments in the alternative online lending space and have engaged with several alternative online lenders over the past few years to learn more about the industry, the technology, and the business models as well as engaging with bankers to understand how these developments are affecting their markets.Most recently, several alternative lenders have participated in events where we have joined with community development finance experts to discuss ways to adopt platform lending technology to better serve low- and moderate-income borrowers and small business owners.
October 4, 2015
We want to better understand the opportunities presented by technological advances that may bring new data to bear and help lenders make available credit to a more diverse set of small business borrowers. In some cases, partnerships between community banks and online platforms may help expand access to credit for consumers and small businesses, and help banks retain and grow their customer base.
As regulators, we also want to help the various stakeholders anticipate and carefully manage the associated risks. Of course, third-party and vendor risks are factors that banks should always take into account when introducing new products and services. Taking the time to identify and mitigate risks is a prudent step that banks can take to avoid unintended consequences when entering into partnership agreements with alternative online lenders. In addition, banks should consider whether the partnerships provide new opportunities to diversify their portfolios if they are purchasing loans, and whether the partnerships provide opportunities to offer new products that are a good strategic fit for their bank and their customers.
It is also important for banks to carefully consider regulatory compliance. When purchasing consumer loans originated by online alternative lenders, banks should examine whether fair lending or unfair or deceptive acts or practices issues result from the origination and underwriting methods used by online alternative lenders. To the extent that the underlying algorithms used for credit decisionmaking use nontraditional data sources, it will be important to ensure that this does not lead to disparate treatment or have a disparate impact on a prohibited basis.
Aside from these risks, banks should consider a variety of others, including the implications of credit risk stemming from the purchase of loans and reputational risk if referrals to online alternative lending platforms end badly.
The risks I have described so far have primarily been from the perspective of banks considering partnerships with online alternative lenders. Another important set of concerns are focused on the small business borrowers who may be considering online alternative loans. Some have raised concerns about the high APRs associated with some online alternative lending products. Others have raised concerns about the risk that some small business borrowers may have difficulty fully understanding the terms of the various loan products or the risk of becoming trapped in layered debt that poses risks to the survival of their businesses. Some industry participants have recently proposed that online lenders follow a voluntary set of guidelines designed to standardize best practices and mitigate these risks. It is too soon to determine whether such efforts of industry participants to self-police will be sufficient. Even with these efforts, some have suggested a need for regulators to take a more active role in defining and enforcing standards that apply more broadly in this sector.