Should Alternative Lenders Expect a Regulatory Tide?

The success of alternative lenders

Alternative lending has been bothering bankers and regulators for a while now as the most successful representatives of the segment hold a rather significant share of loans. In fact, five largest alternative lenders have more than $28 billion worth of loans distributed among them. Lending Club leads the group having disbursed more than $13 billion of loans followed by SoFi which has helped its customers by disbursing loans worth $6 billion followed by Prosper, Avant and LendKey with $5 billion, $2 billion and $1.8 billion of loans respectively. Moreover, Lending Club, one of the largest alternative lenders in the market, shared an expectation of 70% YoY growth in FY 2016 last year.

Alternative lending has proved to be extremely successful with customers and there are at least eight different forms of it. However, everything is not smooth with alternative lending and FinTech in general. There are many cases that had outstanding success but with regulatory complexities and other issues. Banks faced their own challenges as new players came to the sandbox.

While they keep losing on the credit front to alternative players, banks have come to realize that there is only so much that you can gain by competing directly. The largest banks have also built beneficial relationships with the new FinTech players. Bank of America, JPMorgan and others decided to take advantage of the situation and join forces to finance loans given out through alternative lenders.

The rising risks for the industry are catching attention

As alternative lenders gain power in the market and win a large pool of borrowers, the overall risks for the industry are increasing. Every other million dollars given out through a loosely regulated lender is a potential risk.

One of the main concerns for regulators and risks for the whole market is the fact that borrowers that go to alternative lenders are usually the ones that were or will be denied by the banks. Those borrowers are usually trying to refinance their existing excessive debts and will face rejection if they try to get another loan with the bank. Since they have no other options, alternative lenders have the liberty to set their terms. In lending, APR is one of the most important terms one needs to make a note of. One of the largest lenders, Avant, for example, charges between 9.95% and 36% and the story is quite similar with other lenders. Even though the high rates can be justified by the high risks related to the doubtful creditworthiness of borrowers, it is a path to overcharging and taking advantage of the customers.

Another example was brought by TC—some alternative lenders having 70-80% APR range for three-month-term loans, and 30-40% APR for long-term loans (max of 36 months). On the contrary, BofA’s credit cards for small businesses come with an APR of 11-21%.

The situation is even more dramatic with payday loans, which are usually given at rates around 15%. Unfortunately, it’s not the only expense involved and they tend add up to quite a big sum—a 15% rate (or a $15 fee) on a two-week $100 loan results in 390% APR. The $15 example is a democratic one as fees can be higher on payday loans.

Another complication coming from the high rates is a high risk of loan defaults, as professionals fear. Given that large banks pour funds into financing through alternative lenders and will continue to do it, they are exposed to a whole new pool of a risky segment with possible failure of returns. For example, in Q3 2015, alternative lender OnDeck reported an average default rate of 6.4% while small-business default rates for incumbent banks were less than 1%.

The tide is rising

Once the chain comes back to traditional players, regulators can’t stand aside and wait for them to take the fall for the liberty of alternative lenders. A loud concern was recently expressed by Oregon’s Senator Jeff Merkley and US Senators Sherrod Brown and Jeanne Shaheen, who wrote a letter to the US Government Accountability Office (GAO) on April 18. In their official letter, the senators emphasized the importance of regulation of FinTech and lenders in particular.

Observers have questioned what the appropriate role of federal regulators should be in supervising FinTech companies that provide small-business capital and consumer lending, the senators wrote.

…It is possible that the current online marketplace for small-business loans falls between the cracks for federal regulators. As we saw during the crisis, gaps in understanding and regulation of emerging financial products may result in predatory lending, consumer abuse, or systemic issues.

Commenting on the possibilities of abusive practices in alternative lending, the senators said, We are very interested in ensuring that FinTech provides credit to small businesses and consumers in a way that prevents abusive practices while expanding economic opportunity. To that end, we are requesting that the GAO provides information.

There are concerned parties on the other side of the world as well. RBI has recently expressed a concern about alternative lending. The Reserve Bank of India’s (RBI) Deputy Governor R Gandhi has been paying extra attention to P2P lending and shared concerns they impose on investors and the industry in the paper published by the Reserve Bank.

In peer-to-peer lending, there is no investor protection by way of a compensation scheme to cover defaults in this market as there is with deposit guarantee schemes for bank deposits. Retail investors, who do not have capacity to absorb defaults, may lose significant proportions of their investments if there are any defaults, the paper had indicated.

Mr. Gandhi has emphasized the importance of relooking at the alternative players because it is a new innovation and all the sides are needed to be understood.

A little more than a month ago, David Postings, CEO of Bibby Financial Services, shared with the FT his opinion on the warning from Lord Adair Turner, the former Chairman of FSA (the UK’s financial watchdog), that risky loans could cost individual investors.

Mr. Postings compared SME lending situation to the consumer bubble that triggered the 2008 financial crisis.

We are seeing signs of overheating in the small- and medium-sized business lending market. Credit terms are stretched and pricing is down. It has all the hallmarks of what happened to personal credit pre-2007, he commented. He also added that sooner or later, there will be a market crash.

Peer-to-peer is unproven through a credit cycle. The platforms are not at risk but the people who put the cash in could lose everything. If you put your money in a bank, the shareholders take the hit—they are the ones taking the risk, Mr. Postings said to the FT.