Submitted via www.regulations.gov

The Honorable Richard Cordray
Director
Consumer Financial Protection Bureau
1275 First Street NE
Washington, DC 20002

Ms. Monica Jackson
Office of the Executive Secretary
Consumer Financial Protection Bureau
1700 G Street, N.W.
Washington, D.C. 20552

Re: Comments on the Proposed Rule for Payday, Vehicle Title, and Certain High-Cost Installment Loans

Dear Director Cordray:

As a former chairman of the FDIC, a consultant to financial institutions, and a consumer advocate,[1] I am very concerned with the prospect of regulations inadvertently strangling the small-dollar, payday loan market, thereby destroying a lifeline of credit for millions of responsible, low- and middle-income Americans. Thus, prior to the Consumer Financial Protection Bureau’s proposal on payday, vehicle title, and high-cost installment loans (the “Proposal”),[2] I was both hopeful and anxious about the upcoming rules.

In crafting the Proposal, the CFPB had the potential to help tens of millions of Americans who rely on these forms of credit. The CFPB plan could have eliminated regulatory uncertainty, which might have helped spawn innovation and improved lending options. However, I was also concerned that the CFPB might overreach and the rules could have negative, unintended consequences.

The main problem with the Proposal is the likely impact on the consumers who rely on single-payment payday lending. While far from perfect, payday loans are the only real-world source of short-term credit for Americans in many states. In the 35 states that allow single-payment payday loans, the Proposal will eliminate access to credit for millions of working Americans, negatively impacting the people who rely on payday loans for unexpected expenses, such as auto repair and healthcare, or who have fluctuating incomes that they need to smooth.

Why Payday Lending is Vital to Americans

To understand why payday lending is so important to millions of Americans, take a look at some key findings of the Federal Deposit Insurance Corporation’s (“FDIC”) National Survey of Unbanked and Underbanked Households first published in December 2009 (the survey was updated in 2011 and 2013).[3] Roughly 68 million adults, or over one quarter of U.S. households, have limited or no participation in the banking system, which includes over half of black households, close to half of Hispanic and American Indian/Alaskan households, and over 86 percent of lower-income households.

The millions of people who use short-term, fixed-fee loans almost certainly know what is in their own best interests better than anyone else. Payday loans appeal to people because they are convenient, easy to understand, and less expensive than the alternatives. For example, payday loans are nearly always less expensive than overdraft fees. They are less painful than the consequences of defaulting on an auto loan or a mortgage. And they are a better deal than having the electricity and heat turned off only later to pay expensive fees to have them turned back on.

There are people who rail against the products and services of payday lending companies, saying they are predatory and draw lower income people into a so-called “cycle of debt.” While I believe most of these critics are well intentioned, I find it exceedingly frustrating that many of them criticize and try to eliminate one of the most important financial lifelines available to over 70 million working Americans without offering a practical alternative.

Critics argue that payday loans are too short and too costly and these two features combine to trap customers in an endless cycle of debt, thus leading to their conclusion that these loans are predatory. It is very difficult for me to understand how a small, unsecured loan to a high-risk borrower, who understands the terms of the loan clearly, can be predatory. If the borrower defaults, the lender has no collateral to go after and in most cases the loan is too small to justify legal action to collect. The lender’s only recourse is to refuse to make additional loans to that borrower.

Short-term, unsecured consumer loans to borrowers with weak or limited credit histories are priced to cover the risks and costs of providing the service. The loans need to be relatively short term in order to limit the default risk. The typical payday loan is priced at a flat $15 per hundred-dollar loan for two weeks. Critics point out that the Annual Percentage Rate on this loan exceeds 300 percent and they call for short-term lenders to limit the APR to 36 percent.

To achieve a 36 percent APR, the lender would need to limit the fee on a two-week $100 loan to $1.38. While I believe that a more competitive marketplace will likely bring the price meaningfully below $15 per hundred over time, I cannot conceive of anyone willing or able to make $100 two-week unsecured loans for anything close to a $1.38 fee.

Research at the Federal Reserve Banks of New York and Kansas City both show that states that eliminate payday loans immediately experience a substantial rise in costly outcomes. Among other things, these studies find that more households file for bankruptcy when payday loans are no longer available.

Clearly, transparency to the borrower is very important. Research done at Columbia University indicates that most borrowers understand the terms of payday loans and are realistic about how long it will take to repay the loans and at what cost.

I am not claiming that all companies in the payday lending space are complying with all laws and regulations. Nor do I dispute that care must be taken to protect consumers from those who seek to take unfair advantage of them. As with any business, there are good operators in this space and some not so good.

Regulators and law enforcement agencies need to be aggressive with companies that are ethically challenged and are not interested in observing the law. But payday loans are heavily regulated by the states. It is not clear to me that we have done nearly enough research to determine the best regulatory approach, including whether borrowers will be better protected by one federal model versus the many models used in the laboratory of states. My sense is that we are better served by relying on state regulation unless there is a compelling reason for federal intervention, and when we resort to federal intervention it should be as limited as possible.

The Need for More Research

The Urban Institute’s recent study, “Small-Dollar Credit: Protecting Consumers and Fostering Innovation,”[4] (the “Study”) is the latest in an intelligent series of published roundtable discussions about what researchers and regulators know—and do not know—about small-dollar credit. The authors of the Study point out that most research on small-dollar loans focuses on consumers’ needs and behaviors, but is quite light, at best, on the needs and behaviors of lenders. Without a better understanding of lenders’ business models, profitability, loss rates, volume and overhead costs, regulators cannot possibly propose a product that ensures consumers get the credit they need and deserve. The first protection a consumer needs is the assurance that any reforms will not inadvertently drive regulated credit from the market. No lenders, no credit. Or worse, as the authors of the Study note, consumers will be forced to find other, much more expensive products.

One thing seems reasonably certain: banks and credit unions are unlikely to fulfill any meaningful portion of the unmet demand resulting from implementation of the Proposal and the concomitant precipitous drop in the supply of credit. To the extent that such extensions of bank credit are even possible—and they remain effectively proscribed as a result of supervisory guidance regarding deposit-advance products—most banks are poorly equipped to serve these consumers due to high occupancy and unit labor costs and emphasis on higher-balance depositors in tonier, non-inner-city branches. Banks and credit unions are also likely to be unwilling or unable to meet these consumers’ demands for limited documentation, immediate funding and extended operating hours, as payday lenders currently offer.[5] The regulatory guidance giving rise to banks’ exit from this market is discussed below.

The authors of the Study note that most research suggests the overwhelming majority of borrowers need credit because of a family emergency; a temporary, unexpected cash shortfall; or an occasional manageable gap between paychecks. Right now most of these consumers are getting credit when they need it. Regulators must be careful that they do not destroy this supply of credit while trying to help the much smaller percentage of borrowers who probably should not be getting credit at all.

To this end, the authors of the Study offer some suggestions. First, technology changes “more rapidly than the law,” so regulators should not freeze products or procedures in ways that might stifle more effective or efficient technologies coming onto the market. My own experience suggests that this is especially true as new technologies enhance our ability to do quick and accurate underwriting, but it also might apply to other innovative and safe products in the nonbank space.

Second, regulators should not ignore experience for the sake of an abstract ideal. The authors note that payday lenders do not operate in those states with a 36% APR cap, yet many people still advocate that reform. Similarly, almost no licensed lender makes advances to military families anymore due to imposition of the same 36% APR rule. We need to learn from what does and does not—and never will—work.

Third, in an environment in which knowledge is still quite limited, we should not try to do too much too quickly. The states have a long and successful history serving as the laboratories for innovation in bank products and services and regulation. Regulators should look especially at the experiences of states that have made successful changes. The authors note that Colorado’s movement toward small installment loans is quite worthy of study. No doubt there are other states whose models also work well.

Lastly, the authors of the Study suggest that regulatory innovators experiment with “pilots” first and be careful to build proven “safe harbors” into their regulatory innovations so that providers will have confidence they are in compliance with the law. As the authors wisely note, reforms that inadvertently destroy lenders will seriously “disrupt the lives” of consumers without solving their need for credit.

The Urban Institute has done us all a favor by reminding us at the outset of its article that regulatory prudence beats regulatory hubris: “Financial regulations can help protect consumers from harmful practices, but their benefits must be weighed against their potential to drive potential innovators from the market, unnecessarily restrict consumers’ access to credit, or, worse, push consumers toward other more harmful products.”

The Proposal Will Reduce the Availability of Regulated Credit and Takes Away All Incentives for Banks to Enter This Marketplace

Until about three years ago, four relatively large banks (Regions, Fifth Third, US Bancorp, and Wells Fargo) offered a deposit advance product that was competitive in the short-term loan space. The deposit advance product was popular with customers, particularly those with lower incomes, and profitable to the banks which are highly regulated.

However in 2013, the Office of the Comptroller of the Currency issued rules governing non-collateralized, advance deposit loans.[6] Within days of the OCC’s promulgating its rules, every significant bank that offered the product decided to pull it from the market.

The OCC’s 2013 rules imposed strict new underwriting requirements to ensure that the borrower had the ability to repay. The rules limited borrowers to one loan per month, to be repaid within 30 days; imposed a one-month cooling off period between loans; and required a six-month review to determine if the financial situation of the borrower had improved.

The combination of these rules almost guaranteed the product would not solve most borrowers’ credit needs, and thus would not generate enough volume to justify the cost to lenders. Not only do these rules make the product too costly, they also create a regulatory environment where few, if any, banks would be willing to take on the regulatory risk associated with the products. I believe this policy is a disservice to both the banks and their customers and potential new customers.

Unfortunately, I cannot help but fear an even worse outcome from the Proposal: strict new rules for underwriting; a 30-day cooling-off period between loans unless the borrower can prove his or her financial situation has improved; and a mandatory 30-day cooling off period after three successive loans.

These limitations, if implemented, all conspire to the same end. Since most borrowers cannot solve their problems in a month, they will not be able to use this product—and, if they could qualify, they likely would not need it. Indeed, the CFPB’s own data suggest that revenue for a typical payday lender would drop 60% to 75% under the Proposal. The direct effect of this Proposal is to deny consumers needed credit and to put payday lenders out of business. I do not believe this is what regulators should be doing.

Just as with the OCC, the CFPB will be writing regulations that solve neither the credit needs of legitimate borrowers nor the profit needs of legitimate lenders. Even lenders that follow the strict payday rules in states such as Colorado, Florida, and California would not meet the proposed standards. These lenders, already finding their margins quite low, will see their volumes collapse and will have no choice but to exit the field.

No doubt some people would be delighted by the elimination of small dollar non-collateralized loans. This time, however, unlike following the OCC action, as noted above, there will be few, if any, regulated institutions left to fill the void. They will avoid the short-term loan business because of the inability to comply with the impractical underwriting requirements and other restrictions imposed by the rule. No banks or other legitimate short-term lenders will be available. This will leave the business to loan sharks and offshore, unregulated lenders.

The CFPB, as a protector of consumers, should not want this result. You have on many occasions stated that millions of borrowers need small-dollar loans and that most of them do not have relatives who can or would bail them out in times of need.

The CFPB could do enormous harm to millions of consumers by finalizing the Proposal, which will almost certainly shut down regulated short-term lending. Alternatively, the CFPB has the opportunity to learn the lessons from others’ mistakes and put forward thoughtful reforms that not only do no harm, but instead improve the lives of millions of middle and lower income borrowers for whom payday loans are a much-needed, cost-effective lifeline.

The Ability-to-Repay Requirement Will Cause Irreparable Consumer Harm

Much has been written about the Proposal’s potential to effectively drive short-term payday lenders out of business. Part of why many in the industry view the Proposal as so onerous is the “ability-to-repay” requirement.

On the surface, the Proposal may seem sensible—lenders should be required to assess their customers’ ability to repay loans. The CFPB’s concern is that improper underwriting of non-prime credit products may harm consumers due to lawsuits against consumers for nonpayment or possible creation of a “cycle of debt.”

This approach may be in line with regulations governing other credit products and longer-term loans such as home mortgages, but I believe it goes too far and is too complex for small-dollar loans. Additionally, the difficulty of implementing new rules and fairly supervising the industry is significant. I worry about the CFPB’s process to implement the “ability-to-repay” test and supervise lenders without creating unreasonable levels of uncertainty and costs for lenders. This will drive most lenders out of the market, as the CFPB has itself acknowledged.

I believe that the best way to avoid unintended consequences is to create broad incentives for innovation in underwriting without unduly simplistic regulations. We have entered an era of big data innovation that will likely transform underwriting and lead to significant advances in the process for making lending decisions, especially for nonprime consumers.

Enabled by new machine learning technologies, access to new data sources such as social media and real-time bank account information, financial technology companies are in the process of reinventing nonprime lending with a new breed of products and technology. The CFPB should not slow the pace of innovation with outdated, simplistic credit criteria. The key to implementing successful regulations that do not have unintended consequences is to avoid overly prescriptive rulemaking and instead focus on creating a strong and effective supervisory function.

I recommend that the CFPB adopt the same sort of language around ability to repay that is found in the Credit CARD Act of 2009. Under that legislation, lenders are required to use “reasonable written policies and procedures to consider the consumer’s ability to make the required minimum payments under the terms of the account based on a consumer’s income or assets and a consumer’s current obligations.” This provides flexibility to support ongoing innovation while ensuring a framework for ongoing supervision. Another possible improvement to the Proposal would be for the CFPB to offer to “pre-authorize” affordability criteria developed by lenders in advance of the full implementation of the rules.

The CFPB deserves credit for ignoring some of the worst suggestions from various sides of the issues. Among other things, the Proposal excludes an idea circulated by the Pew Foundation and others to create an exemption from the “ability to repay” test for loans with certain features, including a cap on monthly payments of 5% of gross income. This is an arbitrary payment ratio, which provides no information about a consumer’s spending habits or total monthly expenses.

*     *     *

I believe competition is the only practical way to ensure that markets are efficient and offer the best services on the best terms. Instead of using government regulations to remove lawful competitors from the marketplace for services that millions of Americans need and use, we should encourage more competitors to enter this space. Regrettably, the Proposal, in its current form, is headed in the opposite direction.

The CFPB should open up the ability to offer these products and let the marketplace work, reducing prices and giving consumers more and better options. Certainly consumers should be protected from misleading and unfair business practices, but a lawful industry should not be eliminated as the Proposal would do.

The CFPB should encourage, not discourage, more entities to get into the small-dollar, short-term lending business. This will increase competition and lower prices, will allow all firms to participate on a level playing field, and will bring tens of millions of underserved customers into the regulated financial system. I urge that the Proposal be amended to create a more reasonable regulation that prescribes strong consumer protections while allowing these lawful activities to continue in a well regulated environment.

 

Respectfully submitted,
billi

 

 

William M. Isaac
Former Chairman
Federal Deposit Insurance Corporation

 

[1]           From 1978 through 1985, I served as a member of the board of the FDIC and as chairman of the FDIC from 1981 through 1985. In 1986 I founded the regulatory consulting firm The Secura Group, now part of FTI Consulting, where I serve as its senior managing director. My complete biography is attached to this comment letter. The views expressed in this letter are solely those of the author and do not necessary reflect the views of the FDIC or FTI Consulting.

[2]           Payday, Vehicle Title, and Certain High-Cost Installment Loans, 81 Fed. Reg. 47864 (July 22, 2016).

[3]           FDIC, 2013 FDIC National Survey of Unbanked and Underbanked Households (Oct. 2014), available at https://www.fdic.gov/householdsurvey/2013report.pdf; FDIC, 2011 FDIC National Survey of Unbanked and Underbanked Households (Sept. 2012), available at https://www.fdic.gov/householdsurvey/2011/2012_unbankedreport.pdf; FDIC, National Survey of Unbanked and Underbanked Households (Dec. 2009), available at https://www.fdic.gov/householdsurvey/2009/full_report.pdf.

[4]           Signe-Mary McKernan, Caroline Ratcliffe, and Caleb Quakenbush, Urban Institute, Small-Dollar Credit: Protecting Consumers and Fostering Innovation (Dec. 2015), available at http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000556-Small-Dollar-Credit-Protecting-Consumers-and-Fostering-Innovation.pdf.

[5] Stango, Victor, Are Payday Lending Markets Competitive? (2012). Regulation, p. 26, Fall 2012, available at http://ssrn.com/abstract=2155038.

[6]           Guidance on Supervisory Concerns and Expectations Regarding Deposit Advance Products, 78 Fed. Reg. 70624 (Nov. 26, 2013).