Nov 14, 2018

Another Chance at Bipartisan Financial Regulatory Reform?

Brian Knight Director of Innovation and Governance

Don’t look now, but there might actually be an opportunity for meaningful financial regulatory reform despite a politically divided Congress.

The Madden v. Midland Funding decision in the United States Court of Appeals for the Second Circuit has long been controversial, but research on a natural experiment in Connecticut and New York has emerged that should embolden members of Congress interested in fixing the problem created by the Second Circuit’s mistake. While the decision has been applauded by consumer advocates as protecting consumers, this new evidence suggests that the decision has had the opposite effect, leading to a reduction in credit access and a rise in personal bankruptcy filings.   

Briefly, federal law allows banks to loan nationwide on the basis of their charter and using the laws governing interest of their home state. Conversely, non-banks are required to obtain a license in every state they wish to loan into and must comply with the laws governing interest of the borrower. This is one of the reasons that banks and non-bank fintech lenders will partner, with the bank making a loan and then selling all or part of it to the fintech firm for servicing.

The Madden decision held that a loan that was valid and lawful when made by a bank could become usurious and unlawful if it was sold to a non-bank who sought to enforce the loan on its original terms. While the Madden case involved a credit card debt that had gone into default and had been sold to a debt collector, it has had a much broader impact, including the world of innovative fintech lending, because banks making loans and then selling them to others is a key component of the fintech model.

Previous research has shown that in the wake of Madden the amount of funding available for loans to borrowers with relatively low credit scores in the states covered by the Madden decision went down, but supporters of Madden argued that it was unclear whether this meant that consumers were able to get credit from other sources or if they were actually being harmed.  This new evidence seems to indicate that the answers are no and yes.

In their paper, “The Real Effects of Financial Technology: Marketplace Lending and Personal Bankruptcy,” Piotr Danisewicz and Ilaf Elard find that, consistent with prior research, the Madden decision reduced fintech lending volume in New York and Connecticut, two states covered by the Madden decision, and that reduced volume was particularly acute among borrowers with lower incomes and more risky borrowers who would be charged relatively higher interest rates. (In other words, the borrowers who would need to be charged the rates most likely to run afoul of state law in order to attract willing lenders.) They also find that volume for loans sought for the purposes of refinancing existing debt, small business use, and paying for medical procedures sees a significant decline post-Madden. As Danisewicz and Elard point out, this is particularly concerning because those reasons most closely relate to drivers of personal bankruptcy, and if people are not able to obtain loans to address these concerns they may be forced to seek bankruptcy protection.

And sure enough, that appears to be exactly what happened. Danisewicz and Elard find evidence that bankruptcy filings increase significantly after Madden in states affected by Madden relative to other states and among the groups that saw the largest reduction in fintech credit access after the decision. The authors test and reject the possibility that the rise in bankruptcy is driven by borrowers defaulting on fintech loans. They also test and reject the possibility that the rise in bankruptcy is driven by a restriction in credit from traditional lenders or a substitution to higher-interest credit products like payday loans.

So what does this mean? It means that—assuming the findings are accurate—we are, once again, not protecting consumers by denying them a choice. Instead, we are denying people what they believe to be, based on their unique circumstances and preferences, the best option and forcing them to accept a second-best solution. Bankruptcy protection is already available, and for some individuals it may make sense. But other consumers may want to avoid bankruptcy, whether because they want to avoid the penalty to their ability to access credit in the future or because they simply do not want to avoid paying their debts. Fintech lending can serve as an alternative for some borrowers, but not if they are denied the ability to access credit “for their own good.”

As I have discussed elsewhere, the Madden decision is bad, nonsensical, and should be corrected, either by Congress, the bank regulators, or the Supreme Court. The United States Treasury Department recently agreed. Unfortunately, efforts to do so legislatively appear to have stalled, at the continuing expense of vulnerable would-be borrowers. Hopefully, this new evidence helps people realize that access to credit is frequently consumer-protective and that we aren’t helping people by denying them a choice, and the new Congress will reengage with the issue.      

Photo credit: Chip Somodevilla/Getty Images 

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