FAQs on Bank-Fintech Partnerships: Responsible Third-Party Relationships
1. WHO ARE AFC MEMBERS IN THE CONSUMER AND SMALL BUSINESS FINANCIAL SERVICES SPACE?
The American Fintech Council (“AFC”) represents financial technology companies (“fintech”), such as technology platforms, buy-now-pay-later companies, and payment processors, as well as their many partner banks and neobanks, that embrace both consumer protection as a core component of our mission and regulation that advances responsible innovation. The technology platforms of AFC members provide access to credit, payment products and other digital financial services through partnerships with banks. Importantly, our models also rely on the financial support and confidence of investors and stakeholders in the secondary market. The products and services provided through these bank-fintech partnerships facilitate the availability of credit that strikes the right balance between expanding access to credit and services to a broad spectrum of credit risk profiles and providing that access affordably. AFC members advance the highest standards around transparency as well as fairness and nondiscrimination for the products and services we make available.
a. Commitment to credit that is transparent, fair and affordable
A core value of AFC members is to offer products that allow consumers access to affordable credit. To that end, we have supported state legislative efforts to cap the rate on most consumer loans at 36%, although states have defined the calculation differently. While we recognize that this presents the greatest challenge to increasing loan volumes of small dollar consumer loan products, we are committed to finding ways to expand the availability of these products to a broader segment of underserved borrowers and geographies affordably and responsibly. We have and continue to oppose efforts to insert provisions or definitions into state law that disrupt and discourage bank-fintech partnerships and third-party lending relationships.
There is an ongoing and vigorous debate within the financial services industry as well as with consumer advocates about whether fee and interest rate caps help or hurt the availability of credit in underserved communities and banking deserts around the country and whether financial institutions can offer a variety of loan sizes profitably, affordably and at-scale to consumers and small businesses with a range of credit risk profiles, including those that are subprime. Notwithstanding the debate, state laws have sought to drive out higher-cost installment loans and unaffordable payday lending, but have also failed to encourage sufficient responsible credit, and particularly small dollar alternatives, in the private market – products that can and are financed and facilitated in a number of ways today, including through bank partnerships with fintech companies and with the support of private investors through the secondary market.
2. WHY DO BANK-FINTECH PARTNERSHIPS EXIST?
Market competition, federal law and regulations, differing state rules, customer acquisition and servicing costs, pressure on bank net interest margins, technological innovation, and customer preferences all put pressure on the economics of providing financial services. These pressures provide the impetus for banks to partner with fintech companies. Through a bank-fintech partnership, the fintech can leverage its technology platform, customer-reach, application processing, servicing capabilities, and lower costs, to allow the bank to offer products that the bank would not otherwise be able to make as efficiently or at a scalable cost.
The Federal Reserve recognizes that these partnerships can ensure that community banks remain competitive and vibrant.
“The use of third parties can offer banking organizations significant advantages, such as quicker and more efficient access to new technologies, human capital, delivery channels, products, services, and markets. To address these developments, many banking organizations, including smaller and less complex banking organizations, have adopted risk management practices commensurate with the level of risk and complexity of their third-party relationships.”
A 2017 survey of community bankers identified several strategic opportunities afforded by fintech partnerships:
For fintechs, having a bank partner allows the company to scale their online platform and technologies in multiple markets or nationwide. Banks can hold federally insured deposits, process payments and have more experience and a longer track record of existing and prospering under various federal and state regulatory regimes. While the bank partnership can manage some state compliance costs, fintech partners are state licensed and regulated depending on the functions they undertake (e.g., brokering, soliciting, purchasing receivables, servicing, collections). Notwithstanding the benefits of these partnerships, particularly for community banks, the supervisory expectations of regulators regarding bank due diligence of third-party providers can be significant. The FDIC and other regulators review the bank’s performance under their standard examination methods and metrics. Community banks have noted the significant compliance obligations that exist when entering third-party relationships.
3. DO THEY EXPAND ACCESS, FACILITATE FINANCIAL INCLUSION AND FINANCIAL SERVICES IN BANKING DESERTS?
With banking deserts and underserved census tracts proliferating around the country and bank consolidations accelerating, many lawmakers have asked whether bank partnerships with fintechs are helping to fill the geographic gaps as well as reaching underserved consumers and small businesses.
Federal researchers and others have found that bank-fintech partnerships have lowered the cost of financial services in underserved communities. Researchers have documented fintech enabled bank lending in banking deserts, low-income communities and to the “invisible prime” consumers whom other lenders might overlook or overprice. Research from the emergency Paycheck Protection Program (PPP) found that fintech companies accounted for 13 percent of all PPP small business loans, and more than half of those were made as a result of a partner bank relationship. Lending partnerships made more PPP loans in zip codes with fewer bank branches, lower incomes, and larger minority populations.
Bank-fintech lending partnerships as well as the secondary market facilitate the credit needs of millions of consumers and small businesses across the country who have a paucity of affordable options. Loans originated by banks through partnerships with fintechs serve the entire credit spectrum, though most of the consumers served today by AFC members have a near/nonprime or prime credit risk profile. See more selected research in Appendix C2 as well as select survey data in Appendix C1.
4. IS THE CONFIDENCE OF THE SECONDARY MARKET ALSO KEY TO UNSECURED CONSUMER AND SMALL BUSINESS CREDIT?
In addition to the bank and fintech partners, investors drive a great deal of liquidity in the consumer and small business credit markets, including for small dollar loans. The loans that are made in local communities to consumers and small businesses rely on the participation of multiple parties that form a connected, inter-dependent network: banks and finance companies, self-directed and institutional investors, including pension funds, asset managers and insurance companies, managed accounts that purchase loans facilitated through lending platforms, with still some loans or portions of loans held on balance sheet. Two actual transaction structures from 2021 loan securitizations in Appendix A illustrate the network of participants in the secondary market helping to finance and administer a pool of loans to consumers or small businesses of varying credit risk profiles, as well as the diversity of purchasers of loans facilitated by bank-fintech partnerships.
“True lender” and Madden-like (see explanation below) lawsuits and state legislation create uncertainty regarding the enforceability of loans in the hands of non-bank assignees. The nature of these legal and legislative risks have to be disclosed in public filings with the U.S. Securities and Exchange Commission and affect investors’ demand for such loans (and securitizations, debt facilities, and other investments based on such loans) in the secondary market as well as the returns they expect. These risks and uncertainties can reduce loan volumes/the supply of credit, loan sizes, access to unsecured capital for consumers and small businesses, as well as the credit risk profiles and geographies that can be served.
5. WHY IS THERE A DISPUTE ABOUT FEDERAL PREEMPTION OF STATE USURY LAWS AND LICENSING REQUIREMENTS IN LENDING PARTNERSHIPS?
Judges in two seminal, though jurisdictionally limited, cases involving consumer loans ruled that federal banking law did not shield non-bank purchasers of loans originated by a bank from individual state usury requirements. Both decisions – one rejecting the interest rate agreed to in the loan agreement after the loan was assigned and the other rejecting the bank partner named in the agreement as the true lender - have created uncertainty around the enforceability of bank-originated loans in the hands of non-bank assignees. The uncertainty around whether state law claims will succeed in court, as well as the related legislation, rules, and litigation these cases have inspired, has disrupted liquidity in credit markets – chilling investor demand for some loan securitizations, limiting loan origination volumes and loan sizes – and has impacted the availability of consumer and small business credit in some markets.
Valid-When-Made – Madden v. Midland Funding, LLC
The Madden decision in the Second Circuit directly affected three states - New York, Connecticut and Vermont - but upended a long-established principle that “a loan that was valid when made will not be rendered usurious by the transfer.” The National Bank Act (NBA) preempts state usury or interest rate caps by providing in 12 U.S.C. § 85 that a national bank may “charge on any loan...interest at the rate allowed by the laws of the State...where the bank is located.” State-chartered banks have the same authority pursuant to 12 U.S.C. 1831d. The Madden court held that Sec. 85 of the NBA did not preempt a debtor's state-law usury claim against a non-bank entity because that entity was acting as a third-party debt collector rather than on behalf of the originating bank. The court concluded that application of the state’s interest rate cap “would not significantly interfere with any national bank’s ability to exercise its power under the National Bank Act.”
Judges largely have not followed the Madden decision, both the Obama and Trump Administration criticized the decision and, in 2020, federal regulators clarified that interest permissible on a loan is not affected by the subsequent sale, assignment, or other transfer of the loan.
True Lender – CashCall cases
The CashCall cases raised several legal issues and involved very troubling facts around consumer complaints and debt collection practices regarding payday loans. A consumer loan in the hands of the non-bank assignee was rendered uncollectable at the contractually agreed-upon interest rate because the court concluded that the bank that originated the loan was not the “true lender.” In finding that Western Sky (the bank) was not the “true lender,” the judge in the case relied almost exclusively on a “predominant economic interest” test, stating that the “most determinative factor is whether Western Sky [the bank] placed its own money at risk at any time during the transactions, or rather the entire monetary burden and risk of the loan program was borne by CashCall ”. The court neither indicated the amount of economic risk that each party would have to bear under such a test, nor indicated the weight it gave to any other feature of the partnership.
However, courts have applied different standards to resolve true lender claims. In some cases, the court has concluded that the form of the transaction alone resolves the issue - the lender is the entity named in the loan agreement. In other cases, the courts have applied fact-intensive balancing tests in which they have considered a multitude of factors, with no factor dispositive nor any of the factors assessed based on any predictable, bright-line standard.
The CashCall case has motivated similar lawsuits in other jurisdictions, state legislation, and related federal and state scrutiny and enforcement action challenging lending partnerships. Critics of bank lending partnerships have amplified these actions, arguing that bank partnerships are tantamount to “rent-a-charter" and “rent-a-bank" arrangements. This criticism discounts the substantial benefits of these partnerships, their role in facilitating credit for consumers and small businesses and expanding access that is also affordable. It also downplays federal bank examination standards and the significant compliance, due diligence, and risk management requirements around all bank third-party relationships.
6. WHY DOESN’T “PREDOMINANT ECONOMIC INTEREST” WORK AS A TRUE LENDER STANDARD IN STATE LAW?
In short, a predominant economic interest test in state law creates risks and uncertainties for lenders that will reduce loan volumes/the supply of credit, loan sizes, access to unsecured capital for consumers and small businesses, as well as the credit risk profiles and geographies that can be served. While AFC has supported state efforts to make consumer and small business credit affordable, transparent and responsible, we fundamentally oppose efforts to promulgate lender definitions in state law that disrupt and discourage bank third-party lending relationships. These pernicious legislative provisions can undermine secondary market support and confidence in loans made through lending partnerships, make local credit markets less competitive, and reduce the supply of credit that can and has served underserved consumers, small businesses, geographies and a variety of credit risk profiles affordably.
Some states have sought to subject the non-bank fintechs in a lending partnership to state usury and lender licensing laws by expanding the definition of the “lender” beyond the bank that originates and funds the consumer or small business loan. States have proposed legislative language that defines a lender as, among other things, a party that holds, acquires, or maintains, directly or indirectly, the “predominant economic interest” (the “PEI”) in a loan originated by and purchased from a bank. The legislative text picks up language from the Cash Call case (see discussion above). The PEI test creates uncertainty in law for lenders and investors that clouds the enforceability of bank-originated loans that are affordably priced and legally made. This uncertainty chills the desire of fintechs and banks to provide these loans, thereby constricting credit to consumers in these states.
The problem with this test is that it is one-dimensional, overinclusive, and outcome determinative. In determining which entity has the ‘‘predominant economic interest’’ in the transaction, courts, for example, have not necessarily considered all the same factors or given each factor the same weight. Application of the PEI test could cause a court to hold that a purchaser of bank-originated loans in the secondary market is the “true lender,” notwithstanding that the bank approved the origination and loan criteria, funded the loans with its own capital, and complied with all regulatory requirements including consumer compliance and safety and soundness laws and regulations. The bank may have held the loans on its balance sheet for just under half the loan term, receiving just less than 50% of the principal and interest to be paid on such loans. The same outcome could apply if the bank retained a participation interest in such loans but received just less than 50% of the economics associated with such loans.
The risk of such arbitrary outcomes through application of the PEI test (by state statutes that treat the fintech as the “lender” or courts deciding “true lender” challenges) can and has encouraged industry players to limit participation in or exit the credit markets where the PEI test may frustrate their reasonable expectations that bank-originated loans (and investments based thereon) will remain equally enforceable when sold or assigned to non-banks.
Banks and their partners will potentially not make loans or face gray areas that invite litigation by individual states. States will approach the issue differently and arrive at different definitions. Banks and fintech platforms will have to decide where they can do business based on whether a state may define and regulate the fintech as the “lender” regardless of the bank’s status as the “true lender” based on the totality of the circumstances regarding the lending partnership.
a. Are there models for evaluating responsible bank lending partnerships? FDIC’s Proposed FIL-50-2016 and considering the totality of the circumstances
In 2016, the FDIC proposed guidance for bank partnerships that rely on a third party to perform a significant aspect of the lending process, such as some of the following: marketing; borrower solicitation; credit underwriting; loan pricing; loan origination; retail installment sales contract issuance; customer service; consumer disclosures; regulatory compliance; loan servicing; debt collection; and data collection, aggregation, or reporting. Proposed FIL-50-2016 (see Appendix B) sets forth the type of lending arrangements, risk management considerations, minimum standards for the bank’s lending program and supervisory expectations.
Proposed FIL-50-2016 illustrates the kind of factors or totality of the circumstances encompassing “true lender”:
The above are the indicia of a comprehensive third-party lending program that clearly manifest the bank as the “true lender”.
7. DOES THIS CLASS OF CONSUMERS AND SMALL BUSINESSES HAVE BETTER ALTERNATIVES FOR CREDIT?
As policy makers enact laws designed to restrict access to unsecured credit products or to limit loans made through bank partnerships (e.g. by capping interest rates or defining the non-bank fintech partner as the lender), it is important to understand whether consumers and small businesses will have better alternatives available to a range of credit risk profiles and whether those alternatives are more affordable, transparent, and responsible or not. In addition to the affordable credit options made available by AFC members, prime, nonprime, subprime and below borrowers may have other unsecured lending options: a bank credit card or a personal loan from a bank that does not partner with a fintech; overdraft protection; a payday loan; or, secured lending like a pawnshop loan, auto title loan, or rent-to-own. In addition to business credit cards, traditional term loans or lines of credit, small businesses may also tap secured options such as a home equity line of credit, sales-based financing such as a merchant cash advance, factoring, supplier financing or equipment leasing.
AFC’S PRINCIPLES FOR RESPONSIBLE LENDING PARTNERSHIPS
Responsible bank-fintech partnerships are a prime example of how to leverage each party’s expertise to promote healthy competition within the financial services marketplace, ensure that an ample supply of credit is available locally for consumers and small businesses, that a range of credit risk profiles have access, and that loan products are affordable and responsible.
The Bank-Fintech Partnership
To determine if a bank-fintech lending partnership is responsible, one must consider the totality of the circumstances. No one factor alone is entirely determinative of the status of the partnership. Responsible lending partnerships adhere to the factors proposed in the FDIC’s FIL-50-2016 (see Appendix B). Consistent with federal bank examination guidance on third-party-relationships, they outline the roles and responsibilities of each party, such as the requirements for the originating bank to control credit policies, maintain and exercise final approval authority of all marketing materials, apply rigorous oversight of the fintech partner (including periodic audits of the fintech by the bank after thorough vetting at onboarding) to ensure compliance with all applicable laws and regulations, as well as the economic structuring of loan sale arrangements after the bank has originated loans.
Affordable Credit with Clear Terms
Responsible partnerships offer loan products that are affordable and transparent.
Affordable access to credit is a key pillar of a resilient and inclusive financial system. A core value of AFC members is to offer products that allow consumers access to affordable credit. To that end, we have supported state legislative efforts to cap the rate on most consumer loans at 36%, although states have defined the calculation differently. While we recognize that this presents the greatest challenge to increasing loan volumes of small dollar consumer loan products, we are committed to finding ways to expand the availability of these products to a broader segment of underserved borrowers and geographies affordably and responsibly.
Transparency and clarity are essential to promoting products that improve the financial health of consumers and small businesses. Clear, unambiguous terms that help the customer understand the product and exactly what payment schedules will look like are critical in establishing an equitable and responsible lending program. Responsible partnerships ensure their products are provided with clear disclosures, without hidden fees that inflate the prices of the products and do not transparently disclose the cost to the customer.
Skin in the Game
As the “true lender” in the bank-fintech relationship, the bank both originates and funds all loans made through the partnership. It is common practice in the banking industry for banks to sell or securitize loans they make on the secondary market to free up capital to originate additional loans. This process helps expand access to capital and banks’ abilities to originate loans. In responsible partnerships, the originating bank evinces “skin in the game” in any number of ways: funding the loan with its own capital; reflecting the loan on the bank’s balance sheet; retaining a percentage of the loans or a participation interest in the loans; through the advance rate paid by the bank to the fintech and the resultant equity capital used to fund the portfolio. Not only does this encourage lending practices that are consistent with the principles of safety and soundness, but also shows it is truly the bank who is the “true lender” of the loan.
Promotes Responsible Innovation
Responsible lending partnerships are committed to working with the federal and state regulators to create a practical and robust regulatory environment that promote innovation consistent with safe and sound lending and consumer protection.
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About the American Fintech Council: The mission of the American Fintech Council is to promote an innovative, responsible, inclusive, customer-centric financial system. You can learn more at www.fintechcouncil.org.
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