Lynn Woosley is a Senior Director with Treliant. She is a seasoned executive with extensive risk management experience in regulatory compliance, consumer and commercial credit risk, credit and compliance risk modeling, model governance, regulatory change management, acquisition due diligence, and operational risk in both financial services and regulatory environments.
Has COVID-19 created an opportunity for banks and other mainstream lenders to reenter the small-dollar loan market? After years of driving banks out of the market, the current environment has prompted regulators to encourage banks to re-engage in small dollar lending.
In March 2020, the Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve System (FRB), and Office of the Comptroller of the Currency (OCC) issued a Joint Statement on Community Reinvestment Act Consideration for Activities in Response to COVID-19 (CRA Statement).1 The CRA Statement included short-term, unsecured credit products among the activities that would receive favorable CRA consideration.
A week later, the CFPB, FDIC, FRB, OCC, and the National Credit Union Administration (NCUA) issued a Joint Statement Encouraging Responsible Small-Dollar Lending in Response to COVID-19 (Joint Statement).2 The Joint Statement noted that consumers may have unexpected needs for short-term credits because of unexpected expenses or temporary cash flow issues due to the pandemic and associated economic stress. The Joint Statement also recognized that federally supervised banks, thrifts, and credit unions are well-situated to meet short-term and other credit needs of consumers adversely affected by the pandemic. Many such institutions already offer products that could be adapted to meet small-dollar credit needs, such as lines of credit, installment loans, and single payment loans.
Then in May, the five agencies issued Interagency Lending Principles for Offering Responsible Small-Dollar Loans.3 These principles detailed characteristics of responsible small-dollar loan programs, core lending principles, and reasonable policies and risk management practices for responsible small-dollar lending. Characteristics of responsible small-dollar loan programs include:
- A high percentage of customers successfully repay their loans in accordance with original terms;
- Pricing, terms, conditions, and safeguards minimize adverse customer outcomes, such as rollovers and reborrowing; and
- Repay outcomes and program structures that enhance borrower financial capabilities
Responsible small-dollar loan programs must also treat customers fairly, be well-managed, consistent with sound risk management principles and safe and sound banking practices, and well-aligned with institution business plans and strategies.
Also in May, in response to a request from the Bank Policy Institute, the CFPB released a template for use by deposit-taking lenders subject to the CFPB’s authority to use when completing an application for a No-Action Letter on proposed small-dollar lending products. In addition to specifying the information that requestors should submit to the CFPB, the template included “guardrail certifications” that address product structure, maximum loan amount, repayment terms, loan features, underwriting requirements, costs, servicing, and disclosures. In July, the CFPB repealed mandatory underwriting provisions of its 2017 small-dollar lending rule that had been considered burdensome, while retaining the rule’s payment provisions.
Clearly, these regulatory actions show a renewed willingness of federal banking regulators to encourage small-dollar lending by banks and credit unions.
There is a market for small-dollar loans. Approximately 91 million consumers have either subprime credit or too little credit history, making it difficult to qualify for traditional credit.4 Research by the Center for Financial Services Innovation (CFSI) and the Financial Health Network found that an estimated 15 million consumers access small-dollar loans annually.5 Past research by the FRB has shown that approximately 40 percent of adults could not pay an unexpected expense of $400 without using credit or selling something.6 The same report said that over 25 percent of adults have skipped necessary medical treatment because of cost concerns.
Surveys by CFSI found that consumers use small-dollar loans for four primary reasons:7
- Unexpected expenses;
- Misaligned cash flows, especially cash flows related to variable income;
- Planned purchases; and
- Exceeding income.
For borrowers with limited access to traditional credit products, responsible small-dollar loans may help if the consumer is not borrowing because expenses routinely exceed income. During times of extended economic uncertainty, such as the current pandemic, more consumers may need short-term small dollar loans.
Although short-term, small-dollar debt is expensive, bank offerings in this space may be more consumer-friendly than similar products offered by nonbanks. Few banks are currently offering this type of loan, but they have offered similar products called bank deposit advances in the past. These ranged from $7 to $10 per $100 borrowed, with an average fee of $9 per $100 borrowed. For comparison, payday loans of the same time period ranged from $10 to $30 per $100 borrowed, with a typical fee of $15 per $100 borrowed.
In addition, research by the CFSI indicates that 85 percent of bank deposit advance borrowers repaid their first loan on time (and without overdrawing their checking account), compared to only 55 percent of pawn borrowers and 62 percent of payday loan borrowers.8 Overall, the heavily-regulated nature of federally-supervised financial institutions increases the likelihood that small-dollar loans made by banks and credit unions will be offered in a responsible fashion consistent with consumer protection principles. Ongoing supervision and regulation make it less likely that consumer harm will be undetected and unremedied.
Bank small-dollar loan products may offer an avenue for bringing more of the unbanked and underbanked into the banking system. In addition, these products can help a bank meet its community reinvestment obligations by increasing its penetration of low- and moderate-income communities.
On the other hand, offering small-dollar loans carries significant credit risk. The Joint Statement noted that all products, including small-dollar loans, should be offered “in a manner that is consistent with safe and sound practices.” Among other standards, the Interagency Guidelines Establishing Standards for Safety and Soundness require prudent underwriting practices that consider the nature of the markets in which loans will be made.
Subprime Risk. In the case of small-dollar lending, a significant portion of the market is subprime borrowers, often experiencing financial distress. The safety and soundness guidelines also require underwriting practices to consider the borrower’s overall financial condition and resources and the borrower’s character and willingness to repay as agreed. This may be difficult to assess for subprime borrowers with limited credit histories—especially during times of economic distress, such as the current pandemic, when unemployment is high and income stability is uncertain.
Operational Risk. As with any new product, introducing small-dollar loans would add operational complexity and increase operational risk. The lender would need new or revised policies and procedures to govern the product. Depending on current system capabilities, a new or enhanced system may be required to process and service the loans. Banks considering a small-dollar loan product should consider the associated operational risks from errors, breaches, and process or system inadequacies and failures. Appropriate systems and controls will be critical in managing these risks and complying with the Joint Statement’s core lending principle, which underscores that “financial institutions effectively manage the risks associated with the products they offer.”
Reputational Risk. Small-dollar lending also has substantial reputational risk. Consumer advocates have consistently opposed payday loans, deposit advance loans, and some types of early wage access programs, along with auto title loans and similar products. A recent survey conducted for the Center for Responsible Lending found that more than 80 percent of respondents supported prohibiting all high-interest loans during the COVID-19 pandemic, while 70 percent supported mandatory interest rate caps.9
Compliance Risk. Further, small-dollar lending involves considerable compliance and consumer protection risks, including sizable exposures associated with fair lending and Unfair, Deceptive, or Abusive Acts or Practices (UDAAP). Small-dollar loan borrowers are often low- or moderate-income consumers, or members of historically underserved or vulnerable populations.
Risk Mitigation. When marketing small-dollar loans, lenders should ensure the following:
- Marketing materials must be accurate, clear, and transparent.
- Small-dollar credit products must be designed responsibly to support repayment and to avoid excessive loan rollovers, defaults, and other adverse outcomes. (Some loan features, such as balloon payments, increase consumer risk.)
- Pricing should be fair and align borrower and lender success.
- Disclosures must meet the requirements of all applicable state and federal laws, while being understandable to consumers.
- Complaints related to the product should be monitored closely to identify consumer protection risks.
For maximum consumer benefit, the ideal small-dollar loan product creates opportunity to access more mainstream credit products.
Responsible small-dollar loan products may be beneficial to both lenders and consumers. Banks considering adding or expanding their small-dollar loan offerings should carefully evaluate the product fit with the bank’s strategy, as well as the risks and rewards of offering small-dollar loans. Careful attention to consumer protection, including fair lending and UDAAP, is a must in designing, marketing, and servicing small-dollar loans. A robust product risk review function and ongoing monitoring of product performance and consumer outcomes are necessary to properly manage these risks.
1 Joint Statement on CRA Consideration for Activities in Response to COVID-19.
2 Joint Statement Encouraging Responsible Small-Dollar Lending in Response to COVID-19.
3 Interagency Lending Principles for Offering Responsible Small-Dollar Loans.
4 Eric Wilson and Eva Wolkowitz, 2017 Financially Underserved Market Size Study, CFSI, December 2017.
5 Nicholas Bianchi and Rob Leby, Know Your Borrower: The Four Needs Cases of Small-Dollar Credit Consumers, CFSI, December 2013.
6 Report on the Economic Well-Being of U.S. Households in 2017, Board of Governors of the Federal Reserve, May 2018.
7 Rachel Schneider and Jonathan Morduch, Spikes and Dips: How Income Uncertainty Affects Households, CFSI and the Financial Access Initiative at New York University, October 2013.
8 Rob Levy, A Complex Portrait: An Examination of Small Dollar Credit Consumers, CFSI, November 15, 2012.
9 New Data Shows Strong Support for Regulating High-Interest Lending.