FDIC has issued examination procedures for payday lending. These procedures will be applied whenever a bank regulated by the FDIC engages in payday lending, whether directly or through a third party. Occasional small loans to help customers will not be enough payday lending to trigger these procedures. However, commitment to payday lending as a product will trigger a mandatory payday lending examination.
The bank regulatory agencies have weighed in on the risks of payday lending. FDIC joins the crowd. The procedures identify a broad array of risks that concern the FDIC and that examiners should consider.
First is the safety and soundness set of concerns. Payday loans are made with little underwriting. As a matter of routine, payday lenders do not review credit histories or analyze debt considerations of the applicant. The agencies therefore have concerns that payday lending has higher safety and soundness risks because of limited-if-any underwriting and the fact that borrowers tend to be subprime customers.
Not only is there little underwriting, payday borrowers tend to have limited income or financial capacity (which is why they need the payday loan) and the loans are unsecured. These are both red-flag concerns to safety and soundness types.
It is interesting that the bank regulatory agencies approach payday lending with the same analysis process as they would any other type of lending. In fact, payday lending differs substantively from the more traditional bank loan products. Payday lending profits come from the overall performance of a high number of low-amount loans rather than the specific performance of each loan. Payday lenders make loans without significant underwriting knowing that a certain percentage of customers will ultimately not pay. However, the business as a whole is profitable because enough customers do pay. This, however, is not included in the FDIC's risk analysis. Instead, the FDIC looks at the high number of transactions as another source of risk.
Second are reputation concerns. FDIC, as the insurer of deposits, is always concerned about the reputation of the institutions it insures. The reputation risks come from multiple sources. There is the reputation, not always favorable, of lenders who make loans such as payday loans. Then there is risk to the bank's reputation that may result from associating with a third party that fails to conduct business according to bank standards.
Finally, there is compliance risk. The loans are consumer loans subject to all disclosure requirements of Truth in Lending and to the fair treatment of customers required by ECOA.
FDIC's procedures direct that, when an institution is engaged in payday lending, the examinations for safety and soundness and for compliance be conducted at the same time. The concerns in both areas are sufficiently intense to trigger this scheduling requirement.Another deviation from the norm is the direction that the payday lending procedures be followed even if the amount of payday lending does not rise to a level that would trigger the subprime lending examination procedures.
The examination will start at the top. The procedures contain several statements that management of the bank, including the board of directors, must take active and full responsibility for the program. Examiners will be looking for a knowledgeable decision by the directors to institute the program, and a board-supervised written contract with a third party lender if a third party is used. The contract should specifically provide for the duties and responsibilities of each party, require compliance with all applicable laws and regulations, and authorize the bank to review the third party's actions to determine compliance.
Don't enter into such a product line blindly. The procedures ask examiners to take a number of steps to evaluate the institution's capability of managing a payday lending program. For example, examiners will review the due diligence process for selecting any third parties for the program. They will also evaluate whether management has dedicated sufficient staff with the necessary expertise to oversee the third party. It is clearly not enough to sign an agreement that is expected to produce money for the institution and then turn a blind eye to what is going on. Accepting the check means accepting liability.
The procedures also direct examiners to conduct examinations of third parties as appropriate. The authority to do this comes both from the institution's written agreement with the third party which should provide for this, and from statutory powers of the FDIC.
Safety and Soundness
Concerns about payday lending arise under considerations such as concentrations, capital adequacy, classification guidelines, and allowance for loan and lease losses. In each of these areas, examiners will look for and evaluate how the institution evaluated the risk of these loans.
Payday loans, as high risk loans, will trigger more stringent capital requirements. They have "well-defined weaknesses that jeopardize the liquidation of the debt."
One area of safety and soundness that gets special attention is the Retail Classification Policy, establishing the guidelines for renewals and rewrites. This is a significant way that banks differ from a non-financial institution. It is a principle of banking that renewals, deferrals, rewrites and the like for consumer loans occurs because the customer and the loan are high risk. In contrast, finance companies are often structured to rely on rewrites and renewals as the principle source of income. The FDIC is clearly not going to allow banks to use the finance company approach for any lending program.
Examiners will look for policies that restrict the number of extensions, deferrals, and renewals. They will also look for policies that limit the number of additional advances and the extent to which renewal or extension fees can be financed.
There are other ways the FDIC expects financial institutions to keep their distance from finance companies. Financial institutions should have cooling-off periods between payday loans to the same customer. They should also have a maximum number of loans per customer per calendar year and provide that a customer may only have one payday loan with the institution at a time.
Institutions should evaluate the collectibility of fees and charges in addition to interest. Collections or losses must be treated in the same way as other loan products.
In the context of the compliance examination, the procedures identify a full array of regulatory considerations. These begin with CRA. While payday loans may be an important way of meeting credit needs in the institution's assessment area, the procedures direct examiners to consider the negative consequences of payday lending in the context of discrimination, illegal credit practices, and any violations of consumer protection laws. In effect, compliance violations carry a double whammy by having a negative impact on the CRA rating.
It is entirely possible that your market analysis finds a need for payday lending. If so, document your research so that you can support the reasons for choosing the products to meet those needs. Also consider the cost and service benefits of alternative approaches. For example, overdraft checking may be less expensive than payday lending.
Closely related to CRA are concerns of discrimination. In any fair lending analysis, consider not only who the borrowers are or are not in each program and how they are treated. Also consider whether customers are steered to a particular product (with different pricing) on a prohibited basis.
Adverse action requirements of both ECOA and FCRA (if a credit report or third party source is used) apply to payday lending. If denials occur, the program should have notification procedures.
Other compliance concerns include the Fair Debt Collection Practices Act, the possibility of unfair or deceptive trade practices, and compliance with Regulation E if electronic transfers are used in the program. There may even be considerations under Truth in Savings if charges are made to the deposit account.
Finally, all payday lending practices are subject to consumer privacy and safeguarding customer information. If using a third party, this is a particular concern - one which should be provided for in the contract.
- Evaluate your fees and penalties for bounced checks, excess transactions, and late payments to consider whether these may drive customers to payday borrowing as a cheaper alternative.
- Look hard at the credit needs in your market and determine how they can best be met - at the best price and term for the customers. Document your findings!
- Consider the cost and service options of different ways to meet customer needs, including payday lending, skip-payment, and overdraft checking.
- If you are involved in payday lending, use the examination procedures to evaluate your program from top to bottom.
- If you have an agreement with a third party payday lender, read through the contract (and if there isn't a written contract, get one) with a fine-tooth comb. Be sure that all required elements are included.
- No matter who is making the loans or running the program, review customer privacy and how information is safeguarded.
Copyright © 2003 Compliance Action. Originally appeared in Compliance Action, Vol. 8, No. 8, 8/03
First published on 08/01/2003