Online Lending: The Regulator Wagons Are Circlin’

Treasury Department online lending

The Treasury Department released its “timely” assessment of the online lending industry after examining 100 online lenders. The assessment says that technology is a great enabler but to what end? The department has some thoughts on how to answer that question, and one of them, at least, begins with the letter “R.”

The online lending marketplace has had its slew of negative headlines in recent days, with seemingly more issues piling up by the hour. The latest salvo? The industry could use some more oversight and possibly a lot.

That’s one of the key takeaways of a whitepaper released on Tuesday (May 10) by the Treasury Department, titled in a rather generic fashion: “Opportunities and Challenges in Online Marketplace Lending.” Behind the white-bread heading, there are a number of buzzkills for online lending, previously in hypergrowth mode.

The nascent online lending marketplace, though full of promise, also remains “untested” and thus could stand to benefit from greater scrutiny and oversight, with regulation a logical outgrowth of that oversight, as put forth in the paper.

This is hardly a surprise. This report examined 100 online lenders, trade groups and investors, obviously an effort started months and months ago and prompted by concerns over marketplace lenders’ unusual business model and structure.

What is interesting is the timing of its release. Whether coincidental or prescient, the recommendations come just one day after a disclosure by Lending Club that loans were sold against investor and corporate guidelines, which led to the resignation of its founder and CEO. And Prosper, the second-biggest lender, slashed a quarter of its staff as the lending landscape has been proving to be a lot tougher and loan activity has been shrinking.

Low interest rates have spurred lending across technology platforms. The packaging of loans into tranches and risk profiles meant they could be brought directly to lenders with corresponding risk appetites. Streamlined application processes mean that money gets a rather quick turnaround into the hands of those who want it. All of this winds up being a sanguine environment for online lenders, and yet, the Treasury cast a gimlet eye on what might happen should the sunny landscape darken.

Since landscapes, especially in lending and risk management, rarely stay sunny for long.

Among the key risks that the report flags are some of the very innovations that are the foundations of online lending. The whitepaper noted that the data deluge that helps lead to loan decisions comes through algorithms that remain opaque and unchallenged by would-be borrowers directly impacted by such data.

Another risk flagged is banks that might pull in funding — as we have seen Goldman and Jefferies now do with Lending Club — as would other spigots that come in the form of venture capital firms, among other avenues. The new underwriting models that have been well-capitalized to date have yet to be tested through a full credit cycle, said the whitepaper, and defaults have the potential to increase in a changing interest rate environment, a brew that is sure to bubble since interest rates are at historically low levels. Against a tougher interest rate environment, investors will triage their borrowings, choosing, for example, to pay housing loans or auto loans ahead of online borrowings (and thus, debt that is unsecured).

The Treasury’s suggested remedy? As might be expected, government agencies tend to recommend watchfulness on the part of government agencies (and notably, this whitepaper had input from agencies such as the CFPB, the Fed and the FTC, among others). In this case, the Treasury called for greater oversight of the online lending arena, with the creation of a registry that would be used to monitor transactions and disclosures made by firms. On a more microlevel, it also suggests that areas that could benefit from transparency efforts include that standardized data — for the investors and small business owners, especially — should be granted a wider range of protections.