The industry will soon know whether bank-fintech partnerships need more oversight

Current bank-fintech partnerships are a classic example of regulatory arbitrage.

By originating loans on behalf of fintech lenders, who handle all other aspects of the lending process, banks allow their fintech partners to bypass government licensing requirements and interest rate restrictions.

If you think regulatory arbitrage is bad, as most people do, then you’re probably in favor of new rules to limit these so-called rent-a-charter schemes. But not everyone agrees that regulatory arbitrage is inherently flawed. Some researchers have characterized regulatory arbitrage as an economically efficient process that reduces transaction costs.

But this view ignores the purpose of the regulation in question, which is presumably to avoid a bad outcome.

Critics of hire-a-charter schemes argue that the regulations being arbitrated are designed to protect consumers from predatory interest rates. Their view is shared by President Biden, who, during a 2021 signing ceremony repealing the Office of the Comptroller of the Currency’s “genuine lender” rule, said: “In many states, these lenders are kept in check by caps on how much interest they can charge, but some loan sharks and online lenders have figured out how to get around these limits…using a partnership with a bank to avoid the state limit and charge outrageous interest rates…”

The interest rate that counts as usury is of course subjective, since usury rates vary from state to state.

Therefore, an assessment of bank-fintech cooperation should be based on a more detailed analysis than whether a loan granted under such a partnership would be illegal if it had been granted by a fintech.

If the majority of fintech loans lead to the borrower being stuck in a cycle of debt, there is clearly a need for new rules. But there is insufficient evidence to suggest that this is the case. We simply need more time and data to determine whether fintech lending expands access to credit to populations that have historically had no access to affordable, or any, credit and at what cost.

We will soon know more about the impact of fintech loans and the effectiveness of the rent-a-charter model. Fintech lending emerged in the wake of the financial crisis and rode a decade-plus of economic growth and stock market gains. Now that the business cycle has turned, some fintech lenders may realize that their proprietary underwriting algorithm is not as good as they thought. If this happens, fintech lenders could experience a wave of customer defaults and suffer huge losses.

Another risk facing fintech lenders is the potential for investors to stop buying loans. If that happened, most fintech lending platforms would be forced to shut down or at least severely limit new lending. Now that the Federal Reserve is raising interest rates, fintech lenders may be forced to charge borrowers more so they can continue to sell loans to yield-conscious institutional investors. But if borrowers can get lower interest rates elsewhere – say at a bank – they may no longer be willing to borrow from fintech lenders.

If fintech lenders come under stress, so will their banking partners. A select few mid-sized banks have made financing fintech loans a key component of their business model. In what can be aptly described as “dual regulatory arbitrage,” several of these banks are Utah-chartered industrial loan companies, or ILCs. ILCs have virtually all the same powers and privileges as insured commercial banks.

The key difference between ILCs and commercial banks is that ILCs operate under a special exemption from the Federal Bank Holding Company Act, meaning they are not subject to the same Federal Reserve oversight as bank holding companies and therefore are not required to maintain the separation of banking and commerce, which Congress has historically mandated for bank holding companies.

An indirect method of addressing rent-a-charter concerns would be to close the loophole in the ILC that allows commercial ownership of FDIC-insured banks.

It would result in ILC parent companies being subject to consolidated supervision by the Federal Reserve. This would allow the Fed to re-examine bank-fintech partnerships to ensure they do not pose a significant financial or reputational risk to the parent company of the original bank.

Of course, closing the ILC loophole does nothing to stop state and federally chartered banks from making loans to fintech borrowers. At a minimum, federal banking agencies should increase enforcement of existing guidance on third-party relationships, which is designed to regulate activities conducted by banking partners as if they were conducted by the bank itself. This will help curb the worst forms of abuse.

But regulators and Congress would be wise to wait until the current economic downturn subsides and additional data on the performance of fintech lenders is available before taking further steps aimed at limiting bank-fintech partnerships.