Since the financial crisis, regulators and policymakers have concentrated on making brick and mortar banks safe and secure. But, away from regulatory scrutiny, a new sector has emerged led by non-bank online lenders and, if we aren’t careful, it has the potential to harm millions of small business borrowers. Self-policing is a step in the right direction, but increased regulatory vigilance is both warranted and desired.
On August 6 in Washington, a responsible business lending coalition of for-profit online and mission-based lenders, brokers, think tanks and small business advocates announced an agreement on rights that every small business borrower deserves when seeking a loan online, defined as a Small Business Borrowers’ Bill of Rights. This marks a turning point in the small business lending industry. For the first time, online lenders are agreeing to self-regulate and offer fair and transparent terms to small businesses. Any lender or broker will be permitted to sign onto the agreement, by signing a letter from their CEO attesting that they abide by the principles enshrined in the agreement.
Putting these rights at the center of the online lending industry will help foster greater transparency and accountability as the industry matures. That’s important because right now the industry is falling short.
Non-bank online lenders have emerged over the past several years, utilizing glossy user-interfaces that are hallmarks of startups, and opening new points of capital access for small business owners at a time when bank lending to small businesses remains tepid at best. Consultancy Oliver Wyman estimates that $80-120 billion is currently not being met by traditional loan providers, as banks shift activity to more profitable channels. But, while there’s no question that there are many responsible online lenders working to fill this gap, that’s not the whole story. Online lending to small businesses is subject to lax oversight at the federal and state level, making it easier for predatory players to step in.
No federal regulator currently oversees borrower protection in non-bank online lending to small businesses. State usury caps generally don’t apply. Actors aren’t legally required to itemize fees or disclose tools that enable borrowers to make cross-comparisons of loans like annual percentage rates (APRs). And, despite talk of online lending being a technology revolution, the reality is that, depending on the lender, anywhere from 30 to 70 percent of loans are sourced through offline loan brokers. Many of these brokers masquerade as being impartial advocates to help borrowers sort through complicated loan options, but are incentivized by lenders to steer borrowers to loans that are better for the lender and broker’s bottom line.
This sector is small today, representing less than $15 billion in loans originated to date, relative to about $300 billion of small business loans on the balance sheets of banks. But the potential is huge. Morgan Stanley estimates that the total addressable market is nearly $280 billion. The sector is also expected to grow rapidly, with analysts estimating online lending to small businesses will double every other year until at least 2020. “Silicon Valley is coming” as JPMorgan Chase CEO Jamie Dimon recently warned shareholders.
But, the only way to ensure that this sector reaches those heady numbers is by addressing predation head on.
We believe that industry-driven self-regulation is both necessary and worthwhile. However , we also steadfastly believe that self-policing by itself is insufficient to rein in predatory actors. Prudent regulation is still warranted. After all, only regulation could compel every lender and broker to treat borrowers fairly and with dignity. There will always be shady lenders or brokers who refuse to sign the agreement, or live by its principles. And, absent universal standards, it’s considerably more difficult for lenders and brokers to take the high road when competing with irresponsible players which say whatever they wish about their products even if it happens to be deceptive or untrue.
Signs are emerging, albeit slowly, that increased oversight may be on the horizon. Chicago Mayor Emanuel has been an outspoken critic of predatory practices in online lending, and a bill to rein in shady actors is under way in Illinois. State-level vigilance would be a welcome help. Better still would be a single-overseer at the federal level with mission-focus, market-wide coverage, and centralized authority.
We ought to empower the Consumer Financial Protection Bureau, which has experience policing similar abuses in other sectors, to set and enforce first principles that protect borrowers regardless of where they live in America.
The goal would not be to stifle innovation nor to create restrictive rules that turn compliance in online lending into a corner-office endeavor like regulators have done to banking in the post Dodd-Frank era. Rather, the aim would be to put a cop on the beat charged with enforcing basic, commonsense principles driven by the rights that every borrower deserves when seeking a loan.
A few overarching priorities should guide regulation in the new structure.
First, lenders must offer clear disclosure to borrowers about the true and total cost of a loan, including all fees and prepayment penalties. Extraordinarily simple measures such as mandatory disclosure of annual percentage rates (APRs), loan calculators, and terms written in plain English could help borrowers better understand loan options before signing on the dotted line. Best of all would be a cooling off period, which allows borrowers to repay a loan without penalty within a few business days of being funded, as the UK has recently adopted. Could that mean less profit for some lenders? Potentially. But it would also mean fewer small businesses, many of whom are just as untrained in nuances of three-inch thick loan documents as everyday consumers, trapped in products they regret taking out.
Second, lenders must size financing options to meet borrowers’ needs, rather than to encourage borrowers to accept the largest loan for which they qualify. Lenders must also verify a borrower’s ability to repay a loan without having to re-borrow or default, and must be entirely transparent to regulators about how they do this.
Third, loan brokers must be governed by a fiduciary responsibility to borrowers, respecting duties of disclosure, prudence and loyalty. Where conflicts of interest, such as financial incentives to market one lender over another, aren't eliminated they must be disclosed upfront so that borrowers can discount their broker's advice accordingly.It’s only fair. After all, most borrowers trust brokers to help them find loans that best fit their needs, not loans that best compensate their broker.
In the run up to the subprime crisis, those who tried to enforce basic principles that would enable the market to survive were chastened that the "invisible hand" of the market and self-policing could handle the task alone. But the aftermath of the crisis taught us that greed, not self-discipline, rules where unfettered behavior is permitted. It also taught us that independent oversight must exist alongside financial innovation. For the sake of America’s small businesses, we hope regulators don’t have to learn those lessons all over again with the rise of online lending.