Payday Lending, Risk, & Regulators

Payday lending has become an increasingly popular product. And the more popular it gets, the more it gets talked about. The latest word is from the FDIC. That agency has proposed draft examiner guidelines for payday loans. The proposal gives clear signals on how the FDIC views payday lending. In particular, the proposed guidelines outline the risks of payday lending and connect those risks to the traditional issues raised under safety and soundness considerations. The comment period closed on March 14.

Defining The Loans
FDIC's guidance identifies several characteristics for payday loans that distinguish them from other types of loan products. A payday loan is a small-dollar borrowing with a short term. Dollar amounts are usually as low as $100 - enough to make the minimum payment on a credit card bill. Terms are typically 2 weeks or until the next payday.

Payday loans are usually unsecured but carry a promise to repay out of the borrower's next paycheck or social security payment. Some financial institutions tie payday loans to the borrower's checking account and require electronic deposit of paychecks. These carry less risk because the lender pays itself from the deposited paycheck.

Instead of charging interest, payday loans usually charge a fixed fee. The fee may be adjusted to the dollar amount of the borrowing. For example, the fee may by $17 pre $100 borrowed and $34 per $200 borrowed. The resulting APR is shockingly high.

Payment methods are often dictated by the lender. Some lenders take a post-dated check for the loan amount and fee. The borrower must then come in to renew the loan or be prepared to cover the check when it is presented. If the check is presented and the borrower lacks the funds to cover the check, the borrower will face NSF fees from the bank.

Defining Payday Borrowers
Payday borrowers have checking accounts. Most payday lenders require a banking relationship, even if the lender is not a financial institution. Maintaining a bank account is a surrogate factor for creditworthiness.

Payday borrowers are not necessarily unsophisticated. They may be quite the opposite. But typically, the payday borrower will be working with a budget that is very close to the margin. For example, a common reason for borrowing is that the borrower needs funds to make payments on debts to avoid a late payment penalty. The borrower chooses to incur a $17 payday loan fee rather than be hit with a $29 late credit card payment fee.

Risks That Concern Regulators
Payday lending raises traditional safety and soundness concerns. Unsecured loans, made to customers with marginal cash flow with little if any underwriting will always be seen by regulatory agencies as high risk.

The FDIC draft guidelines also give voice to concerns about third party agreements, with particular concerns relating to the legal risks of third-party agreements. Third party agreements exist for two principal reasons. One is that a third party has the skills to offer the product. The other is that the third party is seeking a method for exporting rates using Section 27 of the FDI Act.

FDIC notes that institutions face increased reputation risk when they enter into arrangements with third parties to offer terms and conditions on payday loans that could not be offered by the third party directly. A high risk of third party relationships is the possibility of third party actions that are not consistent with expectations of financial institutions.

To manage the third party risk, FDIC suggests that institutions take specific steps.

First, have everything laid out clearly in a contract. The responsibilities, obligations, and liabilities of each party should be specified.
Second, specify that the third party will comply with all applicable laws and regulations. You might want to specify that the third party must meet the bank's standard of compliance and not allow the third party to define as compliant an action that would be cited in a financial institution.
Third, the contract should specify which party will provide required disclosures - and when.
Fourth, the bank should have access to the third party's records, files, and papers to enable the bank to evaluate the performance of the third party.
Fifth, the FDIC recommends that the contract require the third party to indemnify the financial institution for liability resulting from the actions or inactions of the third party.

Finally, the contract should provide for effective responses to customer complaints.

With these provisions in the agreement, the FDIC also expects that the financial institution will take steps to actively monitor the activities and program of the third party. This is not a sign-it-and-move-on situation.

The Procedures
These proposed examination guidelines would be in addition to, not instead of, the subprime examination guidelines. Moreover, if the institution does not meet the threshold test of a subprime program, the payday lending guidelines will still be applied during the examination.

The emphasis of these procedures is on the management of any payday lending product or third-party relationship. The proposed guidelines instruct examiners to "criticize management and initiate corrective action" when risk management practices are deficient.

Examiners will determine whether the institution has adequate capital to offset the additional risk of payday lending. In the opinion of the FDIC, ordinary minimum capital requirements are not sufficient to offset the risks of payday lending. Examiners are advised to require "significantly higher levels of capital" against payday lending, "the highest risk of subprime lending." The examination workpapers and report should document and evaluate the institution's capital ratios.

The guidelines also direct examiners to give close attention to the Allowance for Loan and Lease Losses Adequacy. FDIC specifically calls attention to more than the principle amounts of the loans. The additional risk to the institution is the ability to collect fees on loans that are renewed or rolled over.

Payday portfolios should be >
Renewals & Rewrites
The FDIC appears to believe that the real risk of payday lending lies in renewals and rewrites. This is where two things happen. First, the cost of the loan escalates with each renewal. Second, the risk that the loan will not be repaid, including finance charges, increases each time the customer is unable to pay.

When reviewing renewals or rewrites, FDIC will look for indications that the borrower is willing and able to repay. Applying the Retail >

limit the number and frequency of renewals;
prohibit additional advances to pay finance charges;
prohibit simultaneous loans to the same borrower; and
maintain strong, accurate reporting and internal controls.

These requirements go to core concerns about predatory lending. The technique often applied by unregulated finance companies is to roll over loans, refinancing some of the fees, until the company has reached the legal lending limit for that type of consumer loan. The customer is then referred to another finance company to borrow enough to pay some fees on the first loan. The referral company happens to be an affiliate. Eventually, the consumer owes the legal maximum to a series of finance companies. The customer is unable to pay anything but the renewal fees on each loan. Eventually, the customer can't afford any more loans.

Consumer Protections
FDIC also wants to see additional procedures and contract provisions in payday lending agreements. These include establishing a cooling off period or waiting period between the time a payday loan is paid off and another application is made. The purpose of a cooling off period would be to ensure that the borrower does not become dependent on the payday loan as a regular feature of the family budget. Another feature would be to limit the number of payday loans that a single customer could take out in one year. Presumably, this limit could include renewals and rewrites.

Finally, the FDIC recommends that banks making payday loans take steps to ensure that there is not more than one payday loan outstanding with the customer at any one time. This would prevent pyramiding loans to increase the amount of debt.

Predatory Concerns
Whether payday lending is predatory or unfair to the borrower depends on how the program is structured. Some practices are clearly costly to the borrower. However, even though costly, the loan could be in the borrowers best interest at the time the loan is made. Renewal and payment practices could change this.

In deciding whether a practice is predatory, you must look not only at the structure of the product itself, but the total cost to the borrower. Whether the cost to the borrower is fair and non-predatory depends both on pricing and on consequences to and choice of the borrower. For example, if the borrower is forced to accept the bounced check fees ($25) that come from check presentation rather than refinancing ($17) , the product may be considered predatory.

Another key element in deciding whether the product is predatory is the timing, content, and clarity of information given to the customer. In this context, information includes not only the required disclosures of Truth in Lending, but also the information presented to customers in advertisements and any other product descriptions or offerings that the borrower may use to make the decision.

ACTION STEPS

If your institution is considering a payday lending program, brief management on the risks and program requirements.
If your institution is offering a payday lending program, compare the design and management of the program to the elements in the FDIC proposed guidance. Make sure you'll pass an examination.
Put payday lending, "bounce protection," and similar products on the table to compare consumer needs and costs - and consider your product options.
This is a good time to take a hard look at fee income. Make sure any fees your institution charges are fair and for a service provided.