It is difficult to fault the OCC for wanting to better understand the risk that third parties might pose to the safety and soundness of banks that they supervise. However, the OCC is not the only agency interested in third-party risk. A national bank would be supervised by the OCC, but its holding company would be overseen by the Fed, and the FDIC would have an interest as well since it manages the Deposit Insurance Fund that guarantees the bank’s deposits.15 The CFPB would also supervise the bank’s activities.
It would make sense for these agencies to coordinate on their expectations for third-party risk management, but that has not always been the case. The result has been overlapping and duplicative requirements that make partnerships between banks and fintechs difficult and time-consuming. In July 2018, the U.S. Department of the Treasury (Treasury) recognized these issues and asked federal regulators to review and harmonize their third-party guidance. Treasury also focused on clarifying when data aggregators are subject to third-party guidance, an issue important to the use of APIs.16 This sets the right direction, although this kind of coordination between federal regulators is easier said than done.
The Current Regulatory System Is Not Well-Designed to Identify and Thwart Bad Actors
One of the most worrisome issues with the current regulatory system is that the new consumer protections put into place after the 2008 financial crisis do not apply to small businesses. These protections are restricted to consumers, largely because small business owners have historically been viewed as sophisticated enough to fend for themselves in lending markets. This means that many rules, including those related to providing borrowers with standardized and understandable information about the terms of their loans (such as annual percentage rate—APR—and repayment terms), are not required for small business or other commercial loans.
Consumer Lending Protections Don’t Apply to Small Businesses
In 2015, the Fed interviewed a group of “mom & pop” small businesses about lending options. The 44 participating businesses had between 2 and 20 employees and less than $2 million in annual revenues, representing a variety of industries and regions of the United States.17 The owners were asked to compare several sample loan products, as shown in Figure 10.2.
Figure 10.2 Loan Options Presented to Small Business Owners—2015
Cleveland Fed Focus Groups and borrower interviews
Source: Barbara J. Lipman and Ann Marie Wiersch, “Alternative Lending through the Eyes of ‘Mom & Pop’ Small-Business Owners: Findings from Online Focus Groups,” Federal Reserve Bank of Cleveland, August 25, 2015.
They were then asked to answer the following question: “What is your ‘best guess’ of the interest rate on product A?” (Figure 10.3).
Figure 10.3 Borrowers Had Trouble Understanding Loan Terms
Small business owners’ guesses of APR on product A
Source: Barbara J. Lipman and Ann Marie Wiersch, “Alternative Lending through the Eyes of ‘Mom & Pop’ Small-Business Owners: Findings from Online Focus Groups,” Federal Reserve Bank of Cleveland, August 25, 2015.
The participants’ answers were all over the map, ranging from 5 percent to over 50 percent. In reality, it is a trick question. The interest rate on Option A cannot be calculated with the information provided because the effective rate would vary depending on how long it took for the borrower to pay back the loan. But many small business owners in the focus groups had answers they perceived to be correct.
From 2015 to 2017, we presented this same exercise to several groups of students and alumni at Harvard Business School and got a similar range of answers. The truth is, even with a financially sophisticated audience, the costs on a relatively simple small business loan can be difficult to understand and compare. The Fed conducted another set of focus groups in 2017, presenting small business owners with financing and loan descriptions similar to those on online lending sites. Again, they saw that small business owners found the descriptions of the loans confusing.18
Nearly all of the small business owners in the 2017 Fed focus groups said they wanted clear, easy-to-understand disclosures about all costs, payment policies, and potential penalties to help them make informed decisions and compare credit offerings. And why shouldn’t they? Such disclosures are helpful in making decisions and are required for consumer, mortgage, and student loans, so why not for small business loans?
Small businesses should be empowered not only to make better credit decisions, but also to protect themselves from predatory and otherwise unscrupulous lenders. Several problems have already emerged in the online lending market, which have caused concern among regulators, policymakers, consumer protection advocates, and responsible lenders. Some of these practices parallel the “four Ds” of predation—deception, debt traps, debt spirals, and discrimination—that former CFPB Director Richard Cordray sought to end in other sectors, such as mortgage, student, and payday consumer loans.
Emerging Issues in Small Business Lending
The most worrisome emerging issues relate to high loan costs and terms that may not be fully disclosed and can make the loan difficult to sustain and repay.
High Costs
There are many ways to evaluate the cost of credit. A borrower can calculate the daily and monthly repayment, financing charges, origination and other up-front fees, the total cost of capital, the interest rate, and the APR of a loan. APR, which measures the interest rate a borrower would pay for credit in a year, is not a perfect metric, but it has become the standard in consumer lending. The APRs of some newer financing products can run well above 50 percent and can reach more than 100 percent.19,20 Although lenders often argue that disclosing APRs does not paint the full picture—and for short-term credit they can be correct—some of these prices are high enough that one wonders how a small business can sustain the loan.
Inadequate or Nonexistent Disclosure of Price and Terms
Borrowers may not even know they are paying high prices because, as we have discussed earlier, disclosures that are required for consumer, student, and mortgage loans do not apply to small business loans. While some responsible lenders have chosen to provide extensive and transparent disclosures, others might disclose the information differently, or not at all. The result is that borrowers don’t have access to clear metrics they can use to shop and compare loans across products and lenders, as they do with consumer loans or auto insurance.
Double Dipping and Debt Traps
Small business owners who borrow short-term credit that they fail to repay are often forced to roll over their debt into another loan, which piles additional fees onto the underlying loan. Rollovers can easily turn into a debt trap in which credit ends up becoming difficult to escape.21 One practice that creates this trap for the small business owner is known as “double dipping,” in which a lender charges a borrower additional fees when their loan is renewed, before the term of the original outstanding loan is complete.
Confusion Over Prepayment Costs
Unlike traditional term loans that amortize over time, the financing charges of some newer short-term products are fixed, meaning that if borrowers repay early, charges are still incurred for the full term of the loan. In the 2017 Fed focus groups, these loans confused many borrowers who thought that paying early would save them interest.22
Misaligned Broker Incentives
Small business loan brokers earn higher referral fees for more expensive products. It can also be difficult for borrowers to understand the costs a broker adds to their loan. Moreover, the lack of disclosure prevents a borrower from understanding when a broker may have incentives that conflict with the best interests of the borrower.
Misaligned incentives can cause major problems, as we saw prior to the 2008 financial crisis, when many mortgage brokers were paid based on the number of mortgages they originated, often with little attention to whether the borrower was able or likely to repay the loan. Borrowers in the Fed focus groups expressed concerns about being bombarded with solicitations by compan
ies and brokers after doing a search for online financing. Discussing the issue of brokers in fintech, the former chief executive officer of Opportunity Finance Network—a trade association of Community Development Financial Institutions (CDFIs)—said, “It’s a direct parallel to what happened in the subprime mortgage space.”23
Policymakers Lack Data on Small Business Lending and Fintech Activity
One overarching issue facing regulators and small business advocates is that it is not clear how pervasive predatory activities and high costs are in the small business lending market. This is because there is no comprehensive data on real-time loan originations and pricing for small business lending. The lack of data leads to the worst of both worlds: legislators and regulators without fact-based analysis are left to respond to anecdotal stories of small businesses that have been taken advantage of by bad actors, and well-meaning lenders are left confused and concerned about how unclear rules will be implemented.
The sources now available—FDIC call report data on commercial and industrial (C&I) lending, Fed surveys, and private sources—are all rough proxies for small business lending. There is no systematic data collection on a host of important areas, such as loan applications and approvals, and the ability of different demographic groups to acquire credit. And there is no information on the costs of the loans. All of this makes it difficult to adequately assess, particularly in real time, the dynamics of the small business lending market and to develop sound policy around it.
Imagine being a member of Congress during the next recession and wondering how you should act on reports of small businesses shuttering their doors around the country and in your home state. It would be hard to respond effectively without good data. And yet, that is the position in which U.S. policymakers have long placed themselves.
A partial solution to this data collection issue was included in Section 1071 of the Dodd-Frank Act, which was passed in 2010. The provision requires the CFPB to gather and review certain data on small business lending. This includes collecting data on loan originations and on fair lending practices, with a particular goal of ensuring that women and minority-owned small businesses receive equitable access to credit. An initial statement from the CFPB indicated that it would act “expeditiously” to develop these rules, but the Bureau focused first on its consumer regulations and fell behind.24 It was not until 2017 that an official request for information was released to help formulate the rules, and little additional progress was made in 2018.25
Section 1071 has also encountered strong resistance from many banks and others concerned about the increased cost burden of collecting the required data. The anticipated difficulties stem from the fact that there is no universal definition of a small business, and that the information required to determine size and ownership is either not collected on applications, or not collected in uniform or reliable ways. Banks and others are also worried that the information will be used after the fact to show bias in lending patterns that was unknown or unintended.
Some of these concerns are understandable. But the answer cannot be to simply do nothing and allow policymakers and regulators to “fly blind” when it comes to small business lending. One proposed solution is to start with data that is available, such as loan originations by loan size, which are currently known by banks and relatively straightforward to report, and if collected could provide enormously valuable information on small business lending markets. In fact, a 2018 Bipartisan Policy Center Task Force on Main Street Finance Report recommended that the OFR collect and store the relevant data and work with the Small Business Administration’s (SBA’s) Office of Advocacy to publish reports and analysis.26 Another approach would be to have a confidential third party, such as a university, collect and hold the data and make it available to academics, policymakers, and legislators on an aggregated basis for analysis and rulemaking. Solutions can be found for the concerns around data collection, and more granular information will undoubtedly improve the ability of both regulators and the market to meet the needs of small business borrowers.
* * *
There is something to be said for light-touch regulation, which can stimulate innovation and benefit borrowers as well as lenders. Since online lenders have had to comply with fewer rules, they have experimented with more creative, automated underwriting techniques that allow them to make faster lending decisions. They have made the credit application experience friendlier by taking advantage of the seamless user interfaces that have become common to online companies. And they have extended credit to a broader range of borrowers than traditional lenders.
But as the Chicago Debacle of 1966 illustrates, limited regulatory oversight has drawbacks too. In the case of online lending, too many lenders have failed to disclose adequate information about prices and terms.27,28 Federal regulators provide little oversight of online small business lending, specifically in regards to borrower protections for small businesses seeking capital, which has created many concerns about predatory lending.
A well-functioning financial regulatory system will help ensure that responsible lenders can compete and expand access to capital for qualified borrowers. Responsible regulation needs to protect borrowers and investors, and mitigate systemic risk, while at the same time promoting innovation. It can be a tricky balance to strike, but it is a balance that is necessary to improve the state of small business lending. In Chapter 11, we suggest some principles for financial services reform that should guide the small business lending regulatory system of the future.
© The Author(s) 2018
Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_11
11. The Regulatory System of the Future
Karen G. Mills1
(1)Harvard Business School, Harvard University, Boston, MA, USA
Karen G. Mills
Email: [email protected]
Fintech innovations will alter the financial system. In the small business lending segment, there will be new lenders and new products and services, many of which will use data in ways that have never before been contemplated. The ownership, security, and use—or misuse—of data will be defining issues in this coming era. Regulatory challenges will accelerate as technology influences more and more parts of the banking and payments industries. We cannot predict the future exactly, but we can be proactive and reform our financial regulatory system to better prepare for the kinds of changes that are coming.
We propose three core principles for how to approach reform and shape future governance. The first principle is to promote innovation by creating an environment that encourages new approaches, and does not allow risk aversion to stifle the potential for exciting and valuable small business products and services to emerge from this fintech revolution. At the same time, there must be guiderails and protections, both for the borrowers and for the financial system as a whole. So the second principle is to protect small businesses, both from “bad actors” we can identify today and also from risks stemming from the new use of data and artificial intelligence. Third, the U.S. regulatory system needs to undergo a streamlining process that will allow it to function more effectively and continue to promote an environment where U.S. financial service firms can be world leaders. These principles draw on lessons from other countries, particularly the United Kingdom and China, and build on industry self-regulation proposals made by some early actors in fintech.
Industry Efforts to Self-Regulate
As hundreds of new fintech players entered the market, many of the first movers in the industry were aware of problems emerging in online small business lending and took steps to self-regulate. The objective was to weed out bad actors and avoid a “race to the bottom” characterized by low transparency and high pricing that could result in responsible players being shut out of the market. The industry also hoped to avoid more stringent government regulation through effective self-regulation.
One of these efforts, the Small Business Borrowers’ Bill of Ri
ghts, was developed in 2015 and updated in 2017 by online lenders such as Lending Club and Fundera, and by non-industry stakeholders such as the Small Business Majority, the Aspen Institute, and the National League of Cities.1 The Small Business Borrowers’ Bill of Rights proposed six “fundamental financing rights” to which the signatories believed small business borrowers were entitled, including the right to transparent pricing and terms, non-abusive products, responsible underwriting, fair treatment from brokers, inclusive credit access, and fair collection practices.2
We believe that these are the right kinds of principles for the industry to adopt, and the Small Business Borrowers’ Bill of Rights remains a worthy template. However, it is only a template, not a detailed guide for implementing regulation. For example, no specific format has been agreed upon for the practice of providing borrowers with information that is easily comparable across loan products, although several groups have proposed solutions. One model was the single-page disclosures for mortgage lenders required by the Consumer Financial Protection Bureau (CFPB). Another suggested format called the SMART Box—developed by an industry group led by OnDeck, Lendio, PayNet, and Kabbage—included the loan and repayment amounts, the cost of capital broken out in detail, interest rate (annual percentage rate—APR), and the term of the loan, on a single page.3
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