Bank lending regulations have rarely been thought of as dynamic or exciting but last night’s ruling by the Consumer Financial Protection Bureau (CFPB) to allow a lender to begin using alternative data in their underwriting could herald the beginning of a new era in lending and how banks work. The CFPB issued a ‘no action letter’ to a marketplace lender called Upstart, giving them the ability make loans using an underwriting process which uses unconventional data.
Why is this significant?
US banks have traditionally been guided by three key pieces of legislation, the Truth in Lending Act of 1968, the Equal Credit Opportunity Act of 1974 and the Community Reinvestment Act of 1977. These three acts were created before the era of personal computers yet still guide bank lending today. Since the rise of marketplace lending, which began in 2006, where borrowers go through a platform and investors fund those loans, it is becoming increasingly apparent that many of these regulations are in need of updating.
In the wording of the letter that was sent by the CFPB, it states ”Staff has no present intention to recommend initiation of an enforcement or supervisory action against Upstart with regard to application of the Equal Credit Opportunity Act (ECOA)2 and its implementing regulation, Regulation B,3 to Upstart’s automated model for underwriting applicants for unsecured non-revolving credit, as that model is described in the Request and confidential Model Risk Management & Compliance Plan (“Compliance Plan”).”
In an overly simplistic interpretation (and I am not an attorney), the regulator is giving an online consumer lender the right to underwrite loans using ‘alternative data’ which before was not in line with how the Equal Opportunity Act is interpreted by lenders. It is not clear what data will be allowed but in a CNBC interview, Upstart co-founder Paul Gu suggested that SAT scores, college grades and even college majors are data points which are helpful in predicting loan defaults. We will likely see more clear guidelines on acceptable types of data over time but the significance of this should not be understated.
It is important to look at this ruling in the context of the US regulatory environment which has no shortage of complexities.
The Consumer Financial Protection Bureau was created in under Dodd Frank Legislation in 2010 as an independent agency but since Republicans took control of Congress, there have been efforts to reform the oversight and management of the CFPB citing a lack of accountability.
There is also a pending court case at the US Court of Appeals around the constitutionality of the CFPB. How would a change in the structure of the CFPB impact this ruling? It is difficult to say but my sense is that Republican Congressmen are more focused on higher profile issues such as forced arbitration for banks. In addition, many Republicans favor more relaxed regulation and the CFPB issuing this no action letter is a step towards a lighter touch regulatory environment for lenders.
Looking at trends in financial regulation outside of the US, we have seen a number of national regulators implement what I call a ‘Regulatory Sandbox” where new ideas are allowed in a controlled way with limitations while regulators look at the impact and results. The US has no formal policy like this but the CFPB did implement a program called “Project Catalyst” whose purpose was to ‘encourage consumer-friendly innovation in markets for consumer financial products and service’ and this no-action letter appears to be a product of that outreach effort.
NC Republican Congressman, Patrick McHenry has been a strong supporter of the Sandbox concept as well as Fintech and has been pushing for greater openness to innovation in US financial regulation (he has been less than complimentary about the CFPB). We should not assume that changes in the structure of the CFPB would necessarily impact this no-action letter.
So assuming the change stands, what is next?
Included in the CFPB’s statement is the following;
“This no-action letter is specific to the facts and circumstances of Upstart and does not serve as an endorsement of the use of any particular variables or modeling techniques in credit underwriting. We encourage other innovators who believe they have a product or service that meet the criteria laid out in our public no-action letter policy to consider our no-action letter process.”
As alternative lenders have more scope to use alternative data, machine learning complex data analysis is opening up an entirely new space for investors. Gone are the days where banks only competed against each other with marketplace lenders now allowing investors to allocate capital in a similar way to banks, choosing loans to fund based on their own ideas and risk profile. For now, this is mostly impacting consumer credit, but in the years to come, look for marketplace lending to impact all areas of lending as investors get more comfortable investing in this space regulations start to adapt.
As a founder of an investment company who invest in marketplace loans, we welcome this move from the CFPB and the implications for further innovation ahead.