Interest Rate Caps Harm Financial Inclusion; Bank Partnerships Spread Inclusion Around

The House Financial Services Committee held a hearing last week on small-dollar lending and proposed legislation that would limit the interest rates on such loans.

As explained in the committee’s hearing memo, many lawmakers are concerned that “payday and car-title loans can be harmful to consumers” and that they “force people that are already struggling financially and underbanked into worse circumstances.” To fix this supposed problem, some members of the committee expressed their support for the Veterans and Consumers Fair Credit Act (H.R. 5050), which would impose a national 36 percent annual percentage rate cap on interest and allow the Consumer Financial Protection Bureau to take punitive enforcement action against lenders that exceed this cap.

While it’s always good to focus on improving the lives of financially strapped consumers, much of the hearing ignored basic economics and how the proposed interest rate caps would further harm poor consumers by likely shutting them out of access to legal credit entirely. As past CEI research and many academic studies have shown, a higher-than-normal interest rate for a small dollar loan makes sense when considering the “fixed costs of running any business—including the costs of operating a storefront, paying employees, the cost of capital, and the cost of bad debts” and the simple fact that “lenders must charge a price that enables them to turn a profit.”

Additionally, as CEI Senior Fellow John Berlau has argued:

Many states have imposed APR limits of 36 percent or lower. While that may sound high, the key word is annual. Divided into 26 two-week periods, the usual duration for most payday loans, this means that payday lenders could only charge $1.38 on a loan of $100.

Further, the Federal Deposit Insurance Corporation (FDIC) estimates that 30 million Americans are underbanked or unbanked and Pew Research has found that 12 million households use small-dollar loans each year to make ends meet. Another study from scholars at the Federal Reserve and George Washington University has shown that lenders would have to lend $2,600 just to break even if a 36 percent rate cap were to go into effect. So much for a small-dollar loan.

Setting such arbitrary limits on interest rates would undoubtedly put lenders out of business and prevent millions of both middle class and struggling Americans from getting accessible and affordable credit.

The hearing also focused on the practice of FinTech-bank partnerships and the concern that non-bank lenders use these partnerships “to export high cost loans, such as small dollar ‘payday’ loans into states with lower interest rate caps.”

Simply defined, a FinTech-bank partnership is where a FinTech financial firm and a bank enter into a business agreement and combine and leverage their capabilities to extend their range of products, especially loans.

While not particularly efficient, this practice has been driven by the lack of a federal charter for FinTech firms. Not having a federal charter makes these financial institutions subject to various state interest rate caps, putting them at a competitive disadvantage against banks that can export loans and instruments like credit cards at the interest rates of their home states.  

But bank partnerships have somewhat filled this gap and provided for innovation in credit. Not only do these partnerships provide access to credit to more than 160 million Americans, they also help those who for various reasons have been excluded from the banking system.

As chronicled by Rodrigo Suarez in BankInnovation:

Here are a few notable successes. Earlier this year, Ally announced a partnership with Better.com to launch a digital mortgage platform. TD Bank’s partnerships with Kasisto, Hydrogen, and others, have helped the bank catalyze its innovation efforts. Goldman Sachs is not only exploring partnerships, they are going a step beyond and acquiring fintech startups to fold into its digital bank, Marcus. First National Bank of Omaha recently launched its innovation lab, in part, to become more effective at partnering with fintech startups. Axos Bank partnered with N26 and Metropolitan Commercial Bank partnered with Revolut for their respective U.S. launches.

There was also significant discussion at the hearing over recent proposals by the Office of the Comptroller of the Currency and the FDIC that  would clarify some of the ambiguity in the light of the court ruling in Madden v. Midland Funding. The Madden case caused great uncertainty by ruling that in some cases, bank loans sold off to non-bank lenders could be subject to the interest rate caps of states other than where the loans were originally made.

While Chairwoman Maxine Waters (D-CA) lambasted the proposals, Democrats seem divided on the issue and there may be room for bipartisanship. In fact, Chairman of the Subcommittee on Consumer Protections and Financial Institutions Gregory Meeks (D-NY) cosponsored legislation by then-Vice Chairman (and now Ranking Member) Patrick McHenry (R-NC) in 2017 that would have codified the legality of bank partnerships.

It seems that the committee will discuss this topic again in part two of the “Rent-A-Bank Schemes and New Debt Traps” series later this month. Hopefully we’ll see less talk about capping interest rates or banning bank partnerships and more action toward ensuring access to credit for responsible consumers. Stay tuned.