Repeal of “real lender” banking rule hurts those most in need of credit
President Biden recently signed a congressional review bill resolution repeal the âreal lenderâ rule promulgated by the Office of the Comptroller of the Currency (OCC). He explained how the action would prevent loan sharks and online lenders from using partnerships with banks to bypass state interest rate caps.
But it would be a huge surprise for regulators at the country’s federal and state banks to know that the banks are partnering with loan sharks.
Political hyperbole aside, the ongoing battle (it has been going on since at least the 1970s) over the jurisdiction of state usury ceilings and the scope of federal preemption is quite complex and is critical to availability and credit allocation. The President and Congress probably think they were helping consumers. But as so often happens when popular slogans are translated into vigorous economic policies, they could not have been more confused as to who would be hurt and who would be helped by this action.
Last September, I wrote about two major Colorado usury cases involving loan deals between banks and fintech companies. In these cases, out-of-state banks were charging their home state rates to residents of Colorado under federal law. Colorado was allowed to opt out of this law, but it did not. For example, loans that slightly exceeded Colorado’s 21% annual percentage rate (APR) usury limit were created and then sold to non-bank fintech companies under partnership arrangements.
The parties settled the state lawsuit, and the OCC and FDIC adopted “valid-once-done” rules. And the OCC enacted its âtrue lenderâ rule to reaffirm that under federal law a bank outside the state could use its home state’s APR (Annual Percentage Rate) and that the subsequent sale of such a loan would not affect its validity. .
No one likes high interest rates, and everyone is critical of interest rate fraudsters. So, it is natural to think that government usage rates are a good thing. But the question is much more nuanced than that.
Small loans are essential for borrowers with bad credit histories, and like the Colorado cases, we’re not talking about situations where APRs exceed 36%. If recent actions by the President and Congress had focused on lending agencies that take advantage of the poorest borrowers and charge outrageous fees and interest rates (some hit triple digits), this could be universally applauded. But that is not what is happening here.
By repealing the âreal lenderâ rule, Congress and the President have once again injected a level of uncertainty into the consumer loan markets, creating financial and legal friction in the plumbing of the economy. Ultimately, these frictions increase the cost of credit and reduce the amount of credit available to borrowers who are at the greatest risk of default. As attractive, popular, and politically expedient as interest rate caps may seem, when deployed without reliance on the facts, they are often a painful remedy for those who need access to credit the most.
Numerous studies have shown that interest rate restrictions can reduce the availability of credit by as much up to 20 percent, and naturally cause a displacement of resources away from compromised credit as credit choices diminish and market competition diminishes. This is because basic business models lead to sound loans.
If a lender has to charge an APR of 25% to make small consumer loans securely and profitably to borrowers with inferior credit histories, and state law says they can only charge an APR of 21%, it is unlikely that he will grant this loan. Frankly, he shouldn’t if he wants to avoid being criticized by his regulator. This is a basic reality that supporters of usury laws ignore. The option of forcing lenders to provide loans to consumers with lower credit scores that cannot be made securely or cost effectively is not always feasible. The lender may be required to simply walk away from the table.
In addition, small loans often necessary for borrowers of lesser means are subject to economies of scale which often increase the APR – the rate to be disclosed -. The APR is not the interest rate. But it is the APR that must be disclosed. For example, since an APR by law must include all fee charged in addition to the interest rate, a six-month loan of $ 500 at 10% interest rate produces an APR of 44% if an administrative and processing fee of only $ 50 is charged. A loan of $ 50,000 with the same terms would have an APR of 10.4%.
We know that high interest rates are a burden on low income borrowers with lower credit histories. If Congress wants to subsidize borrowers, it must do so directly. Distorting and confusing credit models and lending markets is not the way to foster a stable economy. No less authority than the Federal Reserve Bank of Chicago said this “[u]Security laws can only be successful in keeping interest rates below market levels at the cost of reducing the supply of credit to borrowers.
We live in a world where cyberspace has erased borders and borders, and where the 90 percent of consumers are online and thus benefit from a greater choice of financial products and services. A Colorado consumer can access credit anywhere in the country and possibly the world based solely on the amount of time they spend on it, the nature of their credit needs, and their credit history. Laws embedded in state borders are becoming less relevant every day.
There are many good ways to manage the availability of credit, including public / private efforts to increase consumers’ financial literacy and availability of credit. We must avoid simplistic and clunky tools that increase the chances that people will seek illegitimate sources of credit on life-threatening terms.
Thomas P. Vartanian is the author of “200 Years of American Financial Panic: Crashes, Recessions, Depressions, and the Technology That Will Change Everything.” Previously, he was a senior banking regulator in two federal agencies, a private practitioner for four decades, and an academic. He was an expert witness in the recent Colorado cases mentioned in the article.