Federal Interest Rate Cap and Overturning of “True Lender” Rule Threaten Credit Innovation

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On May 11, the U.S. Senate passed a measure, which, though sold as stopping “predatory lenders,” would greatly limit access to credit from solid lenders and harm financial inclusion. The House should refrain from committing the same mistake and defeat the resolution to overturn the “true lender” rule through the Congressional Review Act.

And both houses and the Biden administration should declare dead on arrival legislation, which Senate Banking Committee Chairman Sherrod Brown (D-OH) told Reuters he plans to introduce, to mandate federal price controls on the interest rates of small-dollar loans. Both measures would curtail credit to consumers who most need it as they try to rebuild their lives in the aftermath of a pandemic.

First, let’s go through the specifics of the true lender rule and why it’s so needed at this time when innovative financial technology (FinTech) firms are finding innovative ways to meet credit demand. Finalized last year by the Office of the Comptroller of the Currency (OCC), the true lender rule aims to give some legal clarity to both banks and FinTech firms that are increasingly partnering to provide loans to consumers and small businesses that had previously been left out of bank lending offerings.

As Sen. Pat Toomey (R-PA), Ranking Minority Member of the Senate Banking Committee, said on the Senate floor before the vote (p. S2431 of the day’s Congressional Record), “Community and midsized banks that often lack the resources to develop banking technology in-house are partnering with these FinTechs to compete more effectively and to offer their customers terrific services at ever-better prices.”

A letter signed by groups representing many types of banks, including the Independent Community Bankers of America, echoed Toomey’s points about FinTech partnerships benefiting consumers and banks of all sizes. “When community banks, minority depository institutions, community development financial institutions and midsize, regional, and large institutions partner with technology firms, they can efficiently and conveniently deliver services that customers demand, from a bank that customers trust to meet their financial needs,” the letter stated.

Banks partnering with FinTechs is, in fact, an international trend. In Europe, according to the European Business Review, “Banks are financing the fintech companies, merging their services and products … to form a platform.”

But in the U.S., banks partnering with FinTech lenders face mounting legal confusion. Because courts have been divided over whether the bank or outside firm has primary responsibility for the loan, the partnership may find itself burdened by state regulations from which federally chartered banks have long been exempt. The OCC rule clarifies that the bank is the “true lender,” and thus the loan product is subject to all the regulations governing federally chartered banks as well as the preemption they have long been granted from many state regulatory burdens.

Because the rule means that loans issued by bank-FinTech partnerships would be exempt from state interest rate caps, as most credit cards have been for decades, progressives like Brown have made pseudo-federalist arguments about state sovereignty. “If you believe in states’ rights at all, if you believe in consumer protection at all, there’s no good argument against this,” Brown told Reuters.

Yet in reality, the true lender rule is entirely consistent and even advances the true federalism that the Founders envisioned. As George Mason University law professor and CEI board member Michael Greve puts it in describing what he calls “competitive federalism” in his book Real Federalism: Why It Matters, How It Could Happen, “Real federalism aims to provide citizens with choices among different sovereigns [and] regulatory regimes.”

The optional federal chartering of banks that has existed since the Civil War-era National Bank Act, and preemption of state interest rate caps for national banks that was formalized in the unanimous Supreme Court Marquette decision of 1978 (with a decision argued for by conservative Robert H. Bork and written by liberal William Brennan, two otherwise ideological opposites), allows banks and their customers to weigh the pluses man minuses of federal vs. state regulation. Neither states nor the federal government are perfect, and CEI has long believed the best system of regulation is fostered when they learn from each other by competing with each other, allowing consumers and entrepreneurs to help decide what system of regulation is the best.

In any case, Brown, just a couple weeks after marshaling states rights arguments in favor of defeating the true lender rule, proposed to override the interest rate policies of all states by proposing legislation that would set a national interest rate price control of a 36 percent annual percentage rate. Not only is this legislation affecting every type of financial institution an affront to federalism, it would almost certainly result in a severe shortage of credit for those consumers and small businesses who need it most.

As my colleague Matthew Adams and I point out in our recent CEI OnPoint paper, “Interest rate caps decrease the supply of credit, but the demand remains constant, so borrowers often turn to unsavory alternatives, such as loan sharks, and end up worse off.” In the paper, we also show that the annual percentage rate (APR), which proposed federal and state interest rate caps have been based on, is a bad measure for interest on short-term, small-dollar loans that borrowers usually pay back well before a year has elapsed.

Under the measurement of APR, a short term loan with a 20 percent interest rate if paid back during its duration can suddenly measure as having an official triple-digit interest rate even if the consumer paid nowhere near that amount in interest because he or she completed the loan in less than a year.

As Adams and I conclude, “It is crucial that policy makers understand the limits of the APR as a measuring tool, and do not use it to inadvertently harm the remarkable resilience shown by American consumers and entrepreneurs during this crisis.” Congress should not foment a credit crisis on the heels of a pandemic, and say no to both harmful pieces of legislation.

CEI Research Fellow Ryan Nabil contributed to this article.