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New York State's Flawed Online Lending Report

Earlier this month, the New York Department of Financial Services (NYDFS) released a study of online lending, including findings and recommendations for changes in state law. The report, which included a survey of online lenders, has a number of issues.

To start with, much of the analysis offered up by NYDFS includes no supporting evidence. Repeatedly, the study makes broad assertions without substantiating the claims. For example, the report claims “payday lenders often operate in a regulation-free environment.” That is not correct. Numerous federal statues cover consumer credit generally, such as the Truth in Lending Act, the Equal Credit Opportunity Act, the Electronic Funds Transfer Act, and the Gramm-Leach-Bliley Act. All 50 states also regulate small-dollar loans extensively. Eighteen states and the District of Columbiaincluding New Yorkprohibit high-cost payday lending entirely and Arkansas went so far as to impose an interest rate cap in its state constitution.

Another example is the claim that “[s]mall businesses have reported dissatisfaction with their online loans because of both high interest rates and unfavorable terms that are not often clear to the owners.” Yet, again, no evidence is provided. If this were truly the case, it would be a useful contribution to the academic literature for the data to be made available, especially given that studies looking into these markets have found the oppositeonline lending can be cheaper and fairer than other sources.

The report also makes a number of specious assertions. For example, NYDFS believes that small businesses are exploited by high-interest rate loans, but then goes on to state that:

Finding and affording a loan can be challenging for many small businesses because, historically, costs for depositories to extend small business loans are high compared to the potential returns on those loans. Even when small businesses obtain loans from traditional lenders, they frequently do not receive all the financing they seek. Though banks remain the dominant source of credit, small businesses are increasingly turning to online lenders and lending platforms to obtain funds and lines of credit.

This would seem like a positive result. Small businesses often cannot gain access to financing because they do not fit the strict criteria of larger banks, such as having strong and established credit histories and detailed modelling of business profitability. Even when a local institution is able to underwrite a loan, small businesses often do not obtain all the financing they seek. The fact that new technology has brought new lenders and business models into the marketplace to provide services for small businesses is a positive development. The high interest rates charged on the loans are also likely a genuine assessment of risk, demonstrated by the high level of competition in the marketplace.   

Unsurprisingly, the unsubstantiated claims continue into other arenas. Following the section regarding small-dollar lending, NYDFS attempts to draws parallels between the “predatory lending” of the financial crisis and online consumer lending. It is unclear exactly how the mortgage crisis has implications for small-dollar loans, given the products, market structure, and associated risks are wildly different. NYDFS, however, concludes that private firms preyed on unsuspecting customers during the financial crisis by pushing them into mortgages they could not possibly afford, and that regulations are needed to prevent small dollar lenders from doing the same.

In this respect, the elephant in the room is the omission of any discussion of the two enormous government sponsored enterprises (GSEs) that drove underwriting standards to dangerous lows during the financial crisis. Of all people, the governor who requested this report, Andrew Cuomo, should know this. Indeed, he was the Secretary of the Department of Housing and Urban Development (HUD) who developed and executed “affordable housing goals” for the GSEs in 2000. This increased their holdings of subprime mortgages enormously, with the government backing up to 76 percent of the subprime market by 2008, despite the fact that there was enormous risks inherent in lending to borrowers with weak credit standing and limited financial resources. HUD and the GSEs, perhaps more than any other factor, were responsible for the poor underwriting standards that drove the crisis. But the report makes no mention, merely alluding to a vague conception of private “predatory lending.”

From the flawed analysis of online consumer credit, NYDFS draws even worse conclusions. For example, the report calls for a regulatory framework that draws little distinction between small business and consumer lending. But commercial lending is a completely different animal from consumer lending. For example, a lenders’ predominant consideration in determining whether a consumer is a good credit risk is the consumers’ ability and intent to pay. But the process for a small business loan is completely different. Unlike consumer credit products that typically involve a limited number of variables to be considered in the underwriting process, lending to small businesses is highly tailored and dependent on any number of relevant variables, such as local economic conditions, the competitiveness of a specific industry, assessments of the businesses profitability and longevity, and a host of other factors. Regulating business lending the same as consumer lending is conceptually flawed and will only further the exodus of innovative lenders from the New York market.

Even more contentious, however, is NYDFS’s call for the application of New York usury limits to all online lending. The report takes issue with out-of-state banks exporting their interest rates into New York, and recommends that the state apply its usury limit to such loans. Yet this is directly in contrast to the National Bank Act of 1864 and decades of well-established U.S. Supreme Court precedent. New York would not only drastically reduce credit availability for consumers and small businesses, creating a greater number of unbanked customers in the process, but likely bring forth plenty of litigation challenging the pre-emption. 

The NYDFS online lending report is flawed in a number of ways. It makes dubious legal and economic arguments with little empirical evidence to back it up, omits important historical events that do not support its conclusions, and supports policies that would significantly inhibit credit markets in the state, harming consumers and small businesses alike.