Federal Regulators Greenlight Small Installment Loans From Banks

In July, the federal Consumer Financial Protection Bureau (CFPB) rescinded its well-balanced 2017 safeguards for payday and similar loans with terms of up to 45 days. That change will be a setback for the millions of borrowers who won’t have these protections, but banks can help mitigate the harm.

Payday borrowers have checking accounts and incomes; payday lenders require both as a condition of the loans. Many borrowers are eager for alternatives. About 8 in 10  payday loan borrowers say they would borrow from their bank instead of payday lenders if it offered small loans. Banks, however, have mostly been on the sidelines because of regulatory uncertainty.

But in May, the Office of the Comptroller of the Currency, Federal Reserve Board of Governors, Federal Deposit Insurance Corp., and National Credit Union Administration for the first time issued joint guidance about their expectations for small-dollar lending, alleviating much of that uncertainty. This action is the culmination of years of research and consultation with industry and community stakeholders, as evidenced by prior statements and a formal FDIC request for information. As a result, banks are now well-positioned to offer affordable small loans to their customers who currently use high-cost credit such as payday and auto title loans.

The regulators laid out principles for financial institutions, giving a green light to a simple, low-cost loan origination process. This is a key development, because costly, time-intensive, or difficult requirements to offer loans as small as a few hundred dollars make such loans unprofitable, and therefore make banks less likely to offer them.

Regulators specifically embraced low-cost, automated methods of assessing loan applicants’ ability to repay, including using “internal and/or external data sources, such as deposit activity.” That means banks could assess their own customers’ creditworthiness and issue loans without buying third-party information. This lowers the cost of loan origination for small installment loans or lines of credit and helps to enable fair pricing for consumers.

The FDIC also rescinded a 2007 supervisory letter that encouraged banks to lend at unsustainably low prices (no more than a $24 charge for a $400, three-month loan, a price at which banks do not lend because they tend to lose money). This matters because banks can profitably issue a $400, three-month loan for about $60, or six times less than the $360 average charged by payday lenders.

Potential New Bank Offerings vs. Single-Payment Loans

Comparison by average cost and affordability

Source: The Pew Charitable Trusts

The regulators included several borrower protections in their guidance, encouraging banks to issue only loans “that support borrower affordability and successful repayment of principal and interest/fees in a reasonable time frame rather than reborrowing.” The guidance is meant to encourage creation of programs that have a “high percentage of customers successfully repaying their small dollar loans in accordance with original loan terms” and discourage “cycles of debt due to rollovers or reborrowing.”

Banks will be unlikely to meet these standards by offering single-payment loans, such as deposit advances. Similar to payday loans, these advances often lead to repeat borrowing because they consume such a large share of a borrower’s next paycheck. By contrast, these principles are easy to meet with installment loans and lines of credit, which have small, manageable payments that reduce the loan balance.

Further, in May, the CFPB issued what is known as a No-Action Letter Template that offered additional legal protections to small loans issued by banks or credit unions. Such letters spell out basic conditions under which financial products would not trigger regulatory concerns. The Bank Policy Institute No-Action-Letter Template encourages banks to offer loans repayable over terms of  45 days to a year. These protections largely do not extend to payday loans or deposit advances with terms under 45 days.

Much like the joint guidance, this template envisions simple underwriting “based on criteria including the borrower’s transaction activity in his or her accounts with the [bank]”— a process more commonly referred to as cash flow underwriting. The letter also applies to loans “linked to a borrower’s deposit account at the [bank],” meaning the protections are available only for loans that banks and credit unions issue to their own customers. That is appropriate, because the loans that banks issue to noncustomers involve more risk and more costly underwriting and are occasionally made via high-cost, high-risk partnerships with payday lenders that ignore state laws.

Despite speculation that banks do not want to lend to their customers who would use small loans, Pew has held more than 100 conversations with bank and credit union executives about this topic and found substantial interest in offering small installment loans. Further, people overwhelmingly say they would view banks more positively if they offered such loans, even though the annual percentage rates would be higher than those for credit cards. In surveys, the public (80%) and payday loan borrowers (86%) regard as fair the prices that banks report they would need to charge for such loans.

Small installment loans from banks would be helpful now that the CFPB has abandoned its consumer safeguards for short-term loans, because most nonbank loans in this market will remain extremely risky for consumers. Affordable credit options from banks would create hundreds of dollars in savings annually for typical Americans who today use payday, title, rent-to-own, and other forms of expensive nonbank credit. Pew has published standards for these loans that enable banks to offer them quickly and profitably while keeping them affordable for customers to repay.

Nick Bourke is a director and Alex Horowitz is a senior research officer with The Pew Charitable Trusts’ consumer finance project.