Shining a light into the unknown

When a community bank joins forces with an online lending platform,
the keys to success are transparency and due diligence—on the side
of both parties.

By Kelly Pike

hen MainStreet Bank wanted to increase consumer lending a few years ago, it turned to marketplace lending—after carefully developing a strategy and scoring system to ensure the loans it bought were of the quality advertised.

The $644 million-asset community bank in Fairfax, Va., created its own scoring system and built in statistical sampling to test compliance disclosures from its partner, Lending Club, for accuracy. “I felt very strongly that if we were going to buy these consumer loans, and if we really wished to treat them as loans, we needed to re-underwrite them ourselves, or regulators might have a problem with trusting that third party,” says Jeff Dick, chairman and CEO of MainStreet Bank.

Regulatory scrutiny is just one of the concerns that have kept community banks from buying and selling loans with online lending platforms. While current guidance says marketplace lenders require the same oversight as any other third-party vendor—everything from due diligence and knowledge of the management team’s experience to assurances of compliance—some community banks view marketplace lending as particularly risky. They worry about a fintech firm’s ability to grasp compliance regulations or to understand and test proprietary algorithms, or how untested firms might fare in a downturn.

All of these risks can be mitigated with thoughtful strategy and vendor management. It begins with having strong reasons for entering the market. “If your bank has never bought consumer loans before, and suddenly you’re buying consumer loans from Lending Club, regulators are going to ask why you are doing this and how it fits with your overall approach to lending,” says Chris Cole, ICBA’s executive vice president and senior regulatory counsel. “Are you changing your overall underwriting standards just to buy these types of loans, or are they consistent with what you usually do?”

From there, it’s all about oversight. Marketplace vendors regularly disclose statistical information about loss rates and maturities for each type of loan and provide information about borrowers, including credit scores, net worth and cash flows. That doesn’t guarantee the loss or interest rates of the loans a bank buys. It’s essential to regularly analyze loans for both performance and compliance, testing models, reviewing production and denials, and seeing how the criteria work, says Cole. Good vendor agreements will require the lender to provide a multitude of reports at least monthly, and banks need to analyze them.

“You must be totally on top of the program,” says Lawrence D. Kaplan, a counsel in the global banking and payments systems practice of Paul Hastings in the law firm’s Washington, D.C., office. “In my capacity as a lawyer and former regulator, the world’s worst thing is to get this information and not use it.”

Testing can minimize many risks, because it allows bankers to identify trends and make changes if necessary. It’s especially valuable when working with a lender that uses proprietary algorithms. The data can allow a bank to understand what’s coming out of a black box even if it doesn’t have every detail about what went in, Kaplan says.

“I felt very strongly that if we were going to buy these consumer loans … we needed to re-underwrite them ourselves, or regulators might have a problem with trusting that third party.”
—Jeff Dick, MainStreet Bank

Minimizing compliance risk
Some marketplace lenders use alternative factors for determining creditworthiness. That’s not necessarily a problem, Kaplan says, as long as banks know exactly where and how that information is gathered.

“Under FCRA [the Fair Credit Reporting Act], if you deny credit relying on a report from Experian, borrowers can contact them,” Kaplan says. “If you’re saying, ‘we relied on Facebook likes,’ who is doing the counting? You have to be able to share the methodology and have policies and procedures to address consumer inquiries just like the major bureaus.”

Another area to test is the Equal Credit Opportunity Act (ECOA) and fair-lending rules. Marketplace lenders’ systems are essentially race-blind by design, but that doesn’t mean that an element in an algorithm won’t accidentally become a proxy for race, ethnicity or gender that results in claims of discrimination, Kaplan says.

Community banks can control that risk in several ways, he says. First, they should understand their lending partner’s marketing plan, making sure they are reaching out to broad audiences instead of a specific subset. Second, they should analyze lender reports regularly to know where loans are concentrated. That includes both granted and denied loans. This testing should be done regularly depending on the volume of loans, and should be redone immediately any time the lender tweaks its algorithms.

“Trust, but verify,” Kaplan advises. “Assume they are going to comply with the law, but a lot of times some of the marketplace lenders don’t have the familiarity and regulatory experience a banker does, so the banker has to make sure the square peg fits in the round hole.”

Communication is also key; partnership agreements should incorporate regular meetings and notification of changes, including concerns of fraud.

“It’s really [about] understanding management, trusting management and having a really solid relationship between the two parties, so many of the unforeseen circumstances that can come up in these arrangements don’t come up,” says James Kendrick, ICBA first vice president, accounting and capital policy.

Just as with any other vendor, in the event the company folds, a business continuity plan should ensure another firm is ready to take over servicing.

Selling loans
On the selling side, state usury laws can be a concern. Federal statutes as well as the “valid when made” doctrine allow a bank to export the less restrictive usury laws of its home state to purchasers or assignees in other states, regardless of the importing state’s usury laws. However, the same may not be true for nonbank purchasers or assignees that are not performing essential acts on the bank’s behalf, thanks to the Madden v. Midland Funding LLC case, upheld by the US Court of Appeals for the Second Circuit earlier this year. It ruled that if a loan is transferred to a nonbank, the borrower’s home state may very well dictate the interest-rate limit.

“You have to be careful that the loan is compliant not only with the state of origination but also with the borrower’s state if you’re selling that loan,” Cole says, noting that marketplace lending partners should be aware of and on top of these requirements.

“You have to be careful that the loan is compliant not only with the state of origination but also with the borrower’s state if you’re selling that loan.”
—Chris Cole, ICBA

Though this is an unlikely issue for community banks buying prime loans, a New Jersey-based community bank and its partners are currently suing Colorado state officials after Colorado sued the bank’s marketplace lending partner for acquiring loans in excess of Colorado’s usury limit. ICBA filed an amicus brief defending the bank’s right to export its interest rates.

Test the water
Community banks take on risk whenever they buy loans, Cole says, and marketplace lending is no different. He recommends banks first test the water, buying a small amount to see how they turn out.

“Don’t rush in because a marketplace lender is saying it’s going to go to a different bank,” agrees Kaplan. “So be it. Someone else is coming.”

Kendrick suggests partnering with a lender that regulators have accepted in the past.

MainStreet Bank stopped buying loans from Lending Club a few years ago, after local commercial loan demand picked up. Dick says his regulators seemed happy when the bank ended its marketplace lending relationship, but had never criticized it. “I felt very comfortable with what we did,” he says. “It was a nice play at the time.”

Kelly Pike is a writer in Virginia.