Federal Regulators Should Refrain From Making a True Lender Rule

In the coming weeks, we expect the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) to propose a rule for the “true lender” doctrine, an act that will have a negative impact on the ability of states to protect their residents from high-cost lending.

For centuries, concerns have been raised about the lending of money at unreasonably high rates of interest. The idea of usury – and the need to create laws to thwart it – reaches back to the formative stages of civilization

For numerous reasons, including reputational concerns, most banks shy away from the business of making very high-cost loans to borrowers, and as a result, loans with the highest rates of interest tend to be made by non-bank lenders. Payday lenders are a good example of a high-cost non-bank lender. As a rule, non-banks are regulated by the individual states where they do business, with the states issuing licenses and setting restrictions on interest rates. Many states have established strong interest rate cap rules that have effectively shut down payday lending inside their borders. 

Some non-banks have turned to a “rent-a-bank” strategy as a means of evading restrictive state laws. 

By partnering with a willing bank, these high-cost non-bank lenders hope to reset the rules, seeking a different regulator with a less restrictive viewpoint on interest rates. But such a strategy only works if the non-bank is willing to make the false assertion that it is not the real lender, but is instead an agent of a partner bank who is the actual lender. Through this arrangement, non-bank lenders can hide the fact they are the “true lender” and provide loans that are not subject to state usury laws.  

States routinely use the true lender doctrine to expose these rent-a-bank arrangements for the evasive efforts that they are. However, if the OCC and the FDIC go forward with their own rule, it may weaken the ability of states to use the true lender doctrine, or of equal concern, it could invite future efforts by firms to exploit the rule’s language for new loopholes. For example, a narrowly defined rule would allow unscrupulous non-bank lenders to argue that federal preemption trumps more protective state laws.

At the moment, only a handful of banks engage in these partnerships, and all but one are regulated by the FDIC. A new rule will likely open the floodgate for new high-cost non-bank lenders to escape state oversight.  

Of course, legal issues aside, there is also a question of timing. At a moment when so many households face economic uncertainty, is there an urgency to push the boundaries on the cost of credit? If we know that a racial wealth gap exists in our country, should regulators hasten to let high-cost lenders find more customers for their wealth-extracting debt?

State Oversight Through Usury Laws Is Effective

Some states have used the longstanding true lender doctrine to initiate lawsuits against non-banks that use rent-a-bank schemes. For example, the District of Columbia Attorney General Karl Racine filed a lawsuit against online lender Elevate Credit and its two bank partners just a few weeks ago.

According to the complaint, Elevate offered a line of credit and an installment loan bearing rates of between 99% in partnership with Republic Bank & Trust (Kentucky) and 251% with FinWise Bank. Racine added that 2,551 DC residents took out credit, even though the rates were up to 42 times the District’s respective interest rate caps. Notably, loan products with terms such as these are not unique to Elevate Credit, and in fact, other banks engage in similar partnerships.

To bring his complaint, Racine has asserted that Elevate is actually the true lender, and thus not deserving of the right to avoid DC’s interest rate caps.

If the OCC (and the FDIC) redefine the legal meaning of the true lender doctrine, then it could erase the power of states to pursue these kinds of cases in the future. In addition, there will likely be state legal challenges to any federal action, which will further divert regulatory resources to litigation, instead of protecting consumers.

Federal True Lender Rule Would Encourage Non-Banks to Avoid Oversight

If federal regulators choose to create a strict definition of true lender, it will create immediate problems. Such a decision would effectively challenge enterprising non-bank high-cost lenders to a game of legal whack-a-mole. Below is an example of how a creative non-bank avoids oversight by partnering with a bank:

  1.  Through its own marketing channel, a non-bank state-licensed lender (such as Elevate) finds a customer. The non-bank could offer the loan through a website, over the phone, inside an app or through a storefront. 
  2.  The non-bank brings the application to its partner bank. A necessary feature of the bank, from the perspective of the non-bank, is that the bank is not subject to state interest rate caps. 
  3.  With input from the non-bank’s underwriting algorithm, the partner bank approves the loan and distributes the proceeds of the loan to the applicant. While the borrower may perceive things differently, the disclosures associated with the loan state that the contract is between the applicant and the bank.
  4.  For its role, the bank receives compensation from the state-licensed lender.
  5.  Within a short period (often less than 48 hours) the bank sells the loan – or at least a very high percentage of the outstanding balance – back to the non-bank. It would be rare for the sale of the loan to take place after the first repayment. In some cases, while the loan would not be purchased by the original non-bank, it would be purchased by an entity with a direct financial relationship to the non-bank.
  6.  The non-bank services the loan, handles customer service and engages in collections. The borrower makes payments to the non-bank.

The artful structure of this rent-a-bank approach is only one of half dozen or so methods that have been used by crafty high-cost non-bank lenders to find loopholes to overcome state laws. For example, lenders have devised partnerships with federally-recognized Native American tribes to shield themselves from state laws. In Texas, some payday lenders mutated into “credit service organizations,” a construct of a well-intentioned state consumer protection law, to cloak the same ultra-high cost loans under a different veneer. 

Given the demonstrated willingness of some non-bank lenders to look for loopholes in any rule, leaving the true lender test to the courts makes the most sense. Consumers will fare better if the federal banking regulators leave the true lender test alone.

Adam Rust is a Senior Policy Advisor at NCRC. 

Photo by Josh Appel on Unsplash

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