This blog post was adapted from remarks delivered to CEI’s lunch briefing “Free to Prosper: A Pro-Growth Agenda for the 116th Congress,” held at the Russell Senate Office Building on Capitol Hill.all that was hoped for with regards to financial services reform, it did make important progress to achieving a more free and competitive system by passing Senate bill 2155. However, while S. 2155 was an important bipartisan victory, there was something conspicuously missing—reform of financial technology. This should be a bipartisan priority in the 116th Congress.
Fintech, especially as it relates to consumer and small business lending, is an incredibly promising innovation—it promises to provide credit in a faster, cheaper, and easier way than traditional products like credit cards or installment loans. The problem, however, is that there is no national charter for nonbank lenders, like there is for banks. Banks that gain a federal charter have the ability to “export” their interest rate across the country, charging a uniform rate of interest, but fintech firms do not have that option. This means that if a fintech lender—which isn’t a bank—wants to operate nationally, it has two choices: a) try and get a license and be held accountable by the state regulator throughout the 50 states, which can cost up to $30 million up front (let alone ongoing compliance costs), or b) “partner” with a bank that is nationally chartered and can therefore export their interest rate.
While this arrangement is problematic in itself, it has been made all the more worse by a Second Circuit Court of Appeals decision Madden v. Midland Funding (2017)—a decision which should be fixed by federal legislation.
Madden was a case from the Second Circuit, covering New York, Connecticut, and Vermont, which held that a loan validly made by a bank can become usurious if it is sold to a nonbank financial institution.
More specifically, Madden involved a New York borrower who opened a credit card with a nationally chartered bank that charged an interest rate that was permissible in the bank’s home state but that was higher than the interest rate allowed by the state of New York. When the borrower defaulted, the bank sold the debt to a debt purchaser, Midland Funding, who then sought to collect on the outstanding debt. The Second Circuit held that while the National Bank Act (NBA) preempts state usury limits for nationally chartered banks, it does not preempt state usury limits for the sale of a debt to a nonbank debt buyer, which therefore couldn’t collect on the loan.
While technically unrelated to fintech lending, the case casts doubt on the enforceability of these kinds of loans due to their business model. Because nonbank fintech lenders are not currently chartered at the federal level, they rely on that bank-partnership model to take advantage of the banks’ capability to export their interest rate. The Second Circuit’s Madden ruling, however, made this business model illegal.
The issue with the reasoning in Madden is its neglect of the contractural common law doctrine of “valid-when-made.” The valid-when-made doctrine states that a loan which is valid at the time it was made cannot become usurious upon its transfer to another entity, a doctrine that has been a cornerstone of banking law for nearly two centuries. In the 1833 Supreme Court case Nichols v. Fearson, for example, the court wrote that “Yet the rule of law is everywhere acknowledged, that a contract free from usury in its inception, shall not be invalidated by any subsequent usurious transactions upon it.” Unfortunately, the court failed to consider this fundamental doctrine in its analysis.
Further, the National Bank Act, originally passed in 1863, establishes federal pre-emption of state usury laws for nationally chartered banks. According to 12 U.S. Code § 85, the usury limit for loans originated by national banks is determined by the “interest at the rate allowed by the laws of the State, Territory, or District where the bank is located,” a fact affirmed by the Supreme Court in the 1978 decision, Marquette National Bank v. First of Omaha Serv. Corp. Critically, this pre-emption power conveyed in Section 85 also encompasses the power to transfer the right to enforce the interest-rate of an agreement. 12 U.S. Code § 24, for example, makes clear that an additional power of a nationally chartered bank is the power to sell loans.
Experts from across the political spectrum have criticized the Madden decision. For example, Donald Verrilli, Solicitor General for the Obama Administration, along with the Office of the Comptroller of the Currency, labelled the decision, “incorrect” with an analysis that reflects a “misunderstanding” of Section 85 and Supreme Court precedent.
Not only is the decision in Madden is deeply flawed, but it has proven disastrous for financial technology firms in the Second Circuit.
Two leading studies have examined the impact of Madden decision on credit access and personal bankruptcy, respectively. The first study to observe the economic impact found that the number of loans made to less-creditworthy borrowers in the Second Circuit declined by 52 percent. Meanwhile, the number of loans made to similar borrowers outside of the Second Circuit increased by 124 percent. The second study, written and presented at the Philadelphia Federal Reserve by two university researchers, found a rise in personal bankruptcies of 8 percent in Second Circuit states as a result of the decline in marketplace lending. Overall, the authors concluded that “Our results suggest that withdrawing access to new lending technology has adverse welfare effects in terms of raising the incidence of personal bankruptcy, particularly among households on low incomes.” This result should not come as a surprise, as marketplace loans are commonly used to consolidate debts and provide household liquidity, which reduces the likelihood of bankruptcy.
Without a legislative solution to Madden, the states of New York, Connecticut, and Vermont will miss out on the enormous benefits of new kinds of lending technology. Consumers in those states will be at a continued disadvantage, as they lose access to cheaper and more convenient loans, which have been shown to reduce hardship. Meanwhile, innovative firms have lost access to one of the largest markets in the U.S., demonstrated by the dramatic drop in lending there, reducing their ability to scale and expand their business. In order to embrace the potential of fintech, Republicans and Democrats should come together to pass the “Madden Fix” bill, the “Protecting Consumers’ Access to Credit Act.”