By Brian Knight What Congress can do to help financial innovation and inclusion is a frequent source of discussion on the Hill, but there is rarely a simple answer. Unfortunately, the U.S. Court of Appeals for the Second Circuit has provided Congress with one: undo a recent ruling from the court that threatens credit access and innovation for consumers nationwide.
What is the problem? The New York-based Second Circuit, in Madden v. Midland Funding, ruled that while the National Bank Act allowed a federally chartered bank to charge interest under the laws of its home state on loans it makes nationwide (“interest rate export”), non-banks that bought those loans could not continue to collect that interest. Instead, non-banks are generally subject to the limits of the borrower’s state. While on its face the ruling is limited in scope, applying only to the Second Circuit and federally chartered banks, its impact will likely be much broader, possibly freezing the market for promising new means of consumer credit that thousands have been used to refinance high-cost traditional debts, and preventing robust competition in the consumer credit market. While there is a small chance that the Supreme Court will take up the case, in any event there will be months of delay and uncertainty. Far better for Congress to intervene to modernize banking law and protect consumer credit access.
While some consider Madden a pro-consumer decision, it is anything but. While it did potentially relieve the plaintiff from paying the interest rate she initially agreed to, it presents a significant risk to both innovative and traditional means of credit access, which could leave those most in need of credit least able to get it.
The Madden decision poses a major threat to marketplace lenders (originally known as peer-to-peer lenders). These innovative non-bank lenders, using a combination of advanced algorithms and business processes, have been able to offer many borrowers better rates and terms than they have been able to get from traditional bank credit, including credit cards. Being able to offer consistent terms nationwide is vital to scaling the business, which in turn allows lenders to access cheaper investment capital and pass the savings on to borrowers. (For example, Lending Club, has dropped the rate it charges customers about 1.5 percent from 2014 to 2015.) Because of this need, and to avoid having to navigate 50 separate sets of requirements, marketplace lenders have partnered with banks to take advantage of interest rate export, having the bank make the loan and then purchasing it almost immediately to hold and service.
Madden’s threaten this, without protecting consumers from “usurious” interest, because banks can still export the (frequently unlimited) interest rate rules from their home state for the debt they issue and hold. It is a bitter irony that the allegedly pro-consumer Madden could make it difficult, if not impossible, for consumers to access the products they have increasingly used to get out from under bank debt.
Madden also threatens access to traditional bank credit. Selling debt to non-bank entities, whether non-performing debt like that in Madden or for securitization, is a major part of how banks hedge risk and maintain liquidity. Being unable to do this without the buyer having to comply with 50 different laws will likely force banks to become more restrictive in who they offer credit to and, ironically, increase interest rates for the loans that banks retain ownership in to compensate for the lost revenue and liquidity. This will not benefit customers, especially those with less than perfect histories who still need access to credit. While the problem may not be acute immediately because of the historically low interest rate environment, it will become more serious as interest rates increase and the gap between the price banks pay for capital and state rate caps shrinks.
Fortunately Congress can solve this problem. While ultimately Congress should revise our lending law to reflect the new reality that technological innovation has created, in the short term there is an easy fix. By amending the National Bank Act (for federally chartered banks) as well as the Federal Deposit Insurance Act and Federal Credit Union Act (for state chartered banks and credit unions respectively) to make it explicit that interest rate export follows the loan. Such a fix would reflect the reasonable expectations of both borrowers and lenders, and allow for continued innovation to make credit cheaper and better for everyone. While the Second Circuit misstepped, Congress can act to ensure that consumer choice continues to drive consumer credit.
Brian Knight is an associate director for financial policy at the Milken Institute's Center for Financial Markets.