President Biden recently signed a Congressional Review Act resolution rescinding the “true lender” rule promulgated by the Office of the Comptroller of the Currency (OCC). He explained how this action would prevent loan sharks and online lenders from using partnerships with banks to circumvent state interest rate caps.
But it would be a huge surprise to the country’s federal and state bank regulators to know that banks are partnering with loan sharks.
Putting political hyperbole aside, the ongoing battle (it has been going on since at least the 1970s) over the jurisdiction of state usury caps and the scope of federal preemption is quite complex and is critical to the availability and allocation of credit. The president and Congress no doubt believe that they were helping consumers. But as so often occurs when popular slogans are translated into pithy economic policies, they could not have been more confused about who would be hurt and who would be helped by this action.
Last September, I wrote about two important Colorado usury cases involving lending arrangements between banks and fintech companies. In those cases, out-of-state banks charged their home state rates to Colorado residents under federal law. Colorado had been permitted to opt out of this law, but it failed to do so. So loans that marginally exceeded Colorado’s 21 percent annual percentage rate (APR) usury limit were originated and then sold to nonbank fintech companies under partnership agreements.
The parties settled the lawsuit brought by the state and the OCC and the FDIC adopted “valid when made” rules. And the OCC promulgated its “true lender” rule to reaffirm that under federal law an out-of-state bank could use its home-state APR (annual percentage rate), and that the subsequent sale of such a loan would not impact its validity.
No one likes high interest rates, and everyone is critical of interest rate gougers. So, it is natural to think that state usuary rates are a good thing. But the issue is far more nuanced than that.
Small-dollar loans are critical to borrowers with impaired credit histories, and as in the Colorado cases, we are not talking about situations where APRs exceed 36 percent. If the president’s and Congress’s recent actions had been focused on lending organizations that take advantage of poorer borrowers and charge egregious fees and interest rates (some reach triple digits), it could be universally applauded. But that is not what is happening here.
By rescinding the “true lender” rule, Congress and the president have once again reinjected a level of uncertainty into consumer lending markets, creating financial and legal friction in the plumbing of the economy. Ultimately that friction raises the cost of credit and reduces the amount of credit available to borrowers who pose the greater risk of nonpayment. As attractive, popular and politically expedient as interest rate caps may seem, when they are deployed without reliance on the facts, they are often painful medicine for the people who most need access to credit.
Many studies have shown that restrictions of interest rates can reduce credit availability by as much as 20 percent, and naturally cause a shift of resources away from the credit impaired as credit choices shrink and competition in the market decreases. That is because basic economic models drive sound lending.
If a lender needs to charge a 25 percent APR to safely and profitably make small consumer loans to borrowers with a lesser credit history, and state law says it can charge only a 21 percent APR, it is unlikely to make that loan. Frankly, it shouldn’t if it wants to avoid being criticized by its regulator. This is a fundamental reality that proponents of usury laws ignore. The option of mandating lenders to make loans to consumers with lesser credit scores that cannot be made safely or profitably is not always on the table. The lender may be required to simply walk away from the table.
Moreover, small loans often needed by borrowers of lesser means are subject to economies of scale that often cause the APR – the rate required to be disclosed – to be higher. The APR is not the interest rate. But it is the APR that must be disclosed. For example, since an APR by law must include all fees charged in addition to the interest rate, a $500 six-month loan at a 10 percent interest rate produces a 44 percent APR if an administrative and processing fee of just $50 is charged. A $50,000 loan with the same terms would have an APR of 10.4 percent.
We know that high interest rates are burdensome to lower-income borrowers with lesser credit histories. If Congress wants to subsidize borrowers, it should do so directly. Distorting and confusing credit models and lending markets is not the way to nurture a stable economy. No less authority than the Federal Reserve Bank of Chicago has stated that “[u]sury laws can succeed in holding interest rates below their market levels only at the expense of reducing the supply of credit to borrowers.”
We live in a world where cyberspace has obliterated borders and boundaries, and where the 90 percent of consumers are online and thus enjoy greater choices of financial products and services. A consumer in Colorado can access credit anywhere in the country and perhaps the world subject only to the time she devotes to it, the nature of her credit needs and her credit history. Laws anchored to state boundaries are becoming less relevant each day.
There are many good ways to deal with credit availability, including public/private efforts to increase consumer financial literacy and credit availability. We must avoid simplistic, clumsy tools that increase the chances that people will seek illegitimate sources of credit on life-threatening terms.
Thomas P. Vartanian is the author of “200 Years of American Financial Panics: Crashes, Recessions, Depressions, And The Technology That Will Change It All.” Formerly, he was a senior bank regulator at two federal agencies, a private practitioner for four decades and an academic. He was an expert witness in the recent Colorado cases referenced in the article.