Financial Services Law

Purchased Loans From Alternative Lenders Should Be Accorded the Same Risk Analysis as Originated Loans, FDIC Reminds Banks

Why it matters

In a new advisory, the Federal Deposit Insurance Corporation (FDIC) provided a reminder to all covered entities of the importance of underwriting and administering purchased loans and loan participations as if the loans were originated by the purchasing institution. Financial institutions must understand the loan type, the obligor's market and industry, and the credit models relied upon to make credit decisions, FIL-49-2015 explained, and cannot contract out to a third party the assessment and determination of whether the loans or participations purchased are consistent with the institution's risk appetite and comply with its loan policy guidelines. The guidance updates an earlier advisory from the FDIC and emphasizes that any third-party arrangements to facilitate the purchase process must be managed by an effective third-party risk management process. We believe the imposition of these new requirements may deter banks—particularly smaller institutions—from purchasing loans from online marketplace lenders and others, given the cost of due diligence expected by the FDIC.

Detailed discussion

Having noticed that some banks are overrelying on lead institutions to purchase loans and neglecting to analyze the potential risks arising from the arrangement, the Federal Deposit Insurance Corporation (FDIC) released a new advisory to remind financial institutions to treat purchased loans like originated loans.

FIL-49-2015 set forth effective risk management practices for purchased loans and purchased loan participations, replacing an earlier advisory, FIL-38-2012 on Effective Credit Risk Management Practices for Purchased Loan Participations.

"[A]n increasing number of financial institutions are purchasing loans from nonbank third parties and are relying on third-party arrangements to facilitate the purchase of loans, including unsecured loans or loans underwritten using proprietary models that limit the purchasing institution's ability to assess underwriting quality, credit quality, and adequacy of loan pricing," the FDIC wrote. "Although the FDIC strongly supports banks' efforts to prudently meet the credit needs of their communities, the FDIC expects institutions to exercise sound judgment and strong underwriting when originating and purchasing loans and loan participations."

To that end, the regulator explained its expectations for the policy guidelines of financial institutions. The bank must establish credit underwriting and administration requirements addressing the risks and characteristics unique to the loan types permitted for purchase and should outline procedures for purchased and participation loans, defining loan types that are acceptable for purchase. The policy should require thorough independent credit and collateral analysis, and mandate an assessment of the purchasing bank's rights, obligations, and limitations, the FDIC said.

Concentration limits need to be established as part of the policy and should take into account aggregate purchased loans and participations, out-of-territory purchased loans and participations, loans originated by individual lead or originating institutions, those loans and participations purchased through the same loan broker, and loan type.

The same degree of independent credit and collateral analysis are required for purchased loans or participations as loans originated with the bank, the FDIC emphasized. That means the institution must ensure it has "the requisite knowledge and expertise specific to the type of loans or participations purchased" and obtains all appropriate information. Banks need to consider whether the purchased loans are consistent with the board's risk appetite and comply with loan policy guidelines, both prior to commingling funds and on an ongoing basis. "This assessment and determination should not be contracted out to a third party," the guidance added.

If a financial institution relies upon a third party's credit models for decisions (such as consumer credits), the bank should perform due diligence to evaluate the validity of that model, the FDIC said. "Institutions are not prohibited from relying on a qualified and independent third party to perform model validation," the FDIC said. "However, the purchasing institution must review the model validation to determine if it is sufficient. Such review should be performed by staff that has the requisite knowledge and expertise to understand the validation."

A profit analysis is necessary, the regulator told banks, taking into account the additional costs of obtaining any expertise to properly oversee the purchased loans, as well as the rate of return to determine whether it is commensurate with the level of risk taken.

FIL-49-2015 laid out the necessary information to be included in the written loan sale or participation agreement, from a full description of the roles and responsibilities of all parties to remedies upon default and bankruptcy to dispute resolution procedures. "Institutions should assess thoroughly and understand all the terms, conditions, and limitations of the loan purchase or participation agreements," the FDIC advised, including a possible obligation to make additional credit advances.

Any limitations that the sales or participation agreement places on the purchasing bank—such as the ability to sell or transfer its loan interest or participate in loan modifications—must also be understood, with the use of legal counsel when appropriate. The ability to transfer, sell, or assign its interest in the purchased loans or participations should also be a factor for institutions with regard to liquidity management and credit concentration limits.

For purchased loans out-of-territory or in unfamiliar markets, the FDIC suggested caution and "extensive" due diligence both at the time of the agreement and on a continuing basis, with management keeping an eye on changing economic conditions.

The agency also reminded financial institutions of the need to comply with all existing regulations and requirements, incorporating the purchased loans into the bank's audit and review program, for example, reporting the interests in accordance with generally accepted accounting principles, and ensuring continued compliance with Bank Secrecy Act and anti-money laundering rules.

To read FIL-49-2015, click here.

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FDIC: Providing Accounts and Other Services to Payday Lenders Is OK

Why it matters

Some bank vendors may cautiously smile when the FDIC makes a point that providing accounts and other services to payday lenders is fine, the Federal Deposit Insurance Corporation (FDIC) told banks by reissuing an earlier advisory with some tweaks. "Financial institutions that can properly manage customer relationships and effectively mitigate risks are neither prohibited nor discouraged from providing services to any category of business customers or individual customers operating in compliance with applicable state and federal laws," the regulator wrote in FIL-52-2015. The FDIC's earlier guidance – which emphasized the risks and problems of servicing payday lenders—does not apply to services such as deposit accounts or extensions of credit, the FDIC explained. Whether or not banks are comforted by the new advisory remains to be seen.

Detailed discussion

In 2005, the Federal Deposit Insurance Corporation (FDIC) released FIL-14-2005, guidance on payday lending for banks making such loans directly or through third parties that established the regulator's expectations for prudent risk management practices, covering safety and soundness as well as consumer protection.

Payday lending remains a hot-button topic in both industry and government circles after lawmakers challenged the Department of Justice's (DOJ) Operation Choke Point, claiming it had unfairly targeted payday lending with the help of regulators such as the FDIC using the examination process to direct banks away from the industry. FIL-14-2005 has been cited as one of the examples of the regulator's efforts to discourage banks from working with payday lenders.

Although an internal investigation cleared the agency of any wrongdoing in relation to Operation Choke Point, the FDIC was named as one of several defendants (including the Office of the Comptroller of the Currency and the Federal Reserve Board) in a suit alleging the regulators improperly teamed up with the DOJ.

In an effort to remediate some of the perceived antagonism by the agency toward payday loans, the FDIC reissued FIL-14-2005 in FIL 52-2015, "to ensure that bankers and others are aware that it does not apply to banks offering products and services, such as deposit accounts and extensions of credit, to non-bank payday lenders," the regulator explained.

The changes to the earlier advisory are minor. As amended, the General Examination Procedures section of the guidance now reads: "Examiners should apply this guidance to banks with payday lending programs that the bank administers directly or that are administered by a third party contractor. This guidance does not apply to situations where a bank makes occasional low-denomination, short-term loans to its customers. This guidance also does not apply to banks offering products and services, such as deposit accounts and extensions of credit, to non-bank payday lenders."

In addition, a footnote in the section on Significant Risks reiterates that the "guidance applies only to banks making payday loans. It does not apply to banks offering products and services, such as deposit accounts and extensions of credit, to non-bank payday lenders."

The FDIC emphasized that its position on payday lending was neutral. "Financial institutions that can properly manage customer relationships and effectively mitigate risks are neither prohibited nor discouraged from providing services to any category of business customers or individual customers operating in compliance with applicable state and federal laws," the regulator said. Banks are still advised to solicit the views of their examiner contacts before establishing any new payday lender relationships.

To read FIL-52-2015, click here.

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Preauthorized EFTs on CFPB Radar

Why it matters

Preauthorized electronic fund transfers (EFTs) were the subject of a new Compliance Bulletin issued by the Consumer Financial Protection Bureau (CFPB), discussing the requirements under the Electronic Fund Transfer Act (EFTA) and Regulation E for obtaining consumer authorization for such transactions. The guidance resulted from observations during examinations that some entities are not complying with the relevant laws, the Bureau said, citing companies that failed to provide consumers with the necessary confirmation of terms under Regulation E, for example. The CFPB reminded companies that although consumers may provide their consent for a preauthorized EFT over the phone, the mandates of the Electronic Signatures in Global and National Commerce Act must still be satisfied. In addition, once authorization has been obtained, consumers must be provided with a copy of their authorization in either written or electronic form, providing information on the "important terms" of the authorization such as the recurring nature of the payments, the amount, and the timing of when they will occur. In addition to the industry guidance, the Bureau published tips for consumers about their rights with regard to EFTs, providing sample letters to communicate with their credit union or bank to stop allowing a merchant to take payments from the customer's account. Although these requirements for preauthorized EFTs have been in place for some time, the CFPB's Bulletin likely will draw increased plaintiff's lawyer and regulator attention to merchants that offer "autopay" options for consumers to pay for goods and services.

Detailed discussion

Don't forget the obligations that arise under the Electronic Fund Transfer Act (EFTA) and Regulation E when obtaining consumer authorizations for preauthorized electronic fund transfers (EFTs) from a customer, the Consumer Financial Protection Bureau (CFPB) recently reminded merchants and financial institutions.

Examinations and other observations have shown the Bureau that some entities are not achieving full compliance with the relevant laws and that some are unclear about what the requirements are. Noting that companies across many industries—from mortgage servicing to debt collection to short-term, small-dollar lending—solicit authorizations from consumers for payment via EFTs, the CFPB released Compliance Bulletin 2015-06 to help companies follow the rules.

Defined as an "electronic fund transfer authorized in advance to recur at substantially regular intervals," both the EFTA and Regulation E establish requirements for the use of preauthorized EFTs. First, companies must obtain the proper authorization from consumers. Per Regulation E, authorization can be achieved by a "writing" that is signed "or similarly authenticated by the consumer," and a copy of the authorization must also be provided to the consumer.

There are several ways to obtain the necessary customer approval, the CFPB explained. Authorization is permitted in paper form, electronically, and even over the phone if the requirements for electronic records and signatures under the Electronic Signatures in Global and National Commerce Act (E-Sign Act) are met. That statute establishes the criteria for a valid electronic signature or record.

"Regulation E may be satisfied if a consumer authorizes preauthorized EFTs by entering a code into their telephone keypad, or … the company records and retains the consumer's oral authorization, provided in both cases the consumer intends to sign the record as required by the E-Sign Act," the Bureau said.

Entities should note that any recording of a telephone conversation with a consumer must be conducted in accordance with applicable state law, the CFPB noted.

In addition to obtaining proper authorization, companies need to provide a copy of the terms of the EFT authorization to the consumer. In either paper or electronic form, the company must share important terms such as the timing and amount of the recurring transfers from the consumer's account, the Bulletin said.

CFPB examiners observed in at least one examination that one or more companies provided consumers with a notice of terms for preauthorized EFTs from a consumer's account that did not satisfy Regulation E "because the notices did not disclose important authorization terms such as the recurring nature of the preauthorized EFTs, or the amount and timing of all the payments to which the consumer agreed."

Entities do have an alternative option to providing a copy of the authorization after its execution if they use a confirmation form. "For instance, a company may provide a consumer with two copies of a preauthorization form, and ask the consumer to sign and return one and to retain the second copy," the Bureau said. "However, a company does not satisfy Regulation E by only making a copy of the authorization available upon request in lieu of providing the copy."

With the reminder available to all entities, the CFPB said it expects companies obtaining consumer authorizations for preauthorized EFTs to know and comply with all legal requirements, obtaining the necessary authorization before initiating the EFTs, providing a copy of the authorization to consumers and, when practical, encouraging entities to provide the copy of the authorization to the consumer before the first preauthorized EFT is initiated.

"If the CFPB determines that an entity has engaged in acts or practices that violate EFTA and Regulation E, or any other Federal consumer financial law, it will take appropriate supervisory or enforcement action to address the violations and seek all appropriate corrective measures, including remediation of harm to consumers and assessment of civil money penalties," the Bureau warned.

EFTA provides for a private right of action for violations of the EFTA, including requirements applicable to preauthorized EFTs. The CFPB Bulletin, suggesting that some merchants or financial institutions are not in compliance with EFTA and Regulation E autopay requirements, may attract plaintiff's attorney attention.

To read the CFPB's Compliance Bulletin 2015-06, click here.

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House Passes Bills to Circumscribe CFPB Authority

Why it matters

Congress pushed back against multiple Consumer Financial Protection Bureau (CFPB) initiatives recently, passing legislation that would override the Bureau's policies with regard to auto lending and mortgage lending. Passed by a voice vote, the Reforming CFPB Indirect Auto Finance Guidance Act would repeal the Bureau's Compliance Bulletin 2013-02, which offered guidance to indirect auto lenders on compliance with federal fair lending laws. A second bill—the Portfolio Lending and Mortgage Access Act—was similarly passed by a voice vote. That measure would amend the Truth in Lending Act and Regulation Z to establish exemptions and safe harbors for depository institutions with regard to Qualified Mortgages and the Ability-To-Repay Rule. While both pieces of legislation have moved to the Senate for consideration, their passage is unlikely. In addition to facing Democratic opposition in the Senate, President Barack Obama has indicated his disapproval of the bills. After each proposal was passed, the White House released a statement expressing opposition to the legislation.

Detailed discussion

In 2013, the Consumer Financial Protection Bureau (CFPB) released Consumer Bulletin 2013-02, providing guidance to indirect auto financing companies and taking the position that the practice of "dealer markups" would be challenged by the Bureau under a disparate impact theory of discrimination. Critics charged the Bureau with overstepping its bounds, particularly as the CFPB released the guidance without a public notice and comment period. Or as Rep. Jeb Hensarling (R-Texas), Chair of the House Financial Services Committee, characterized it, the Bureau "went far beyond clarifying existing law and instead is attempting to make new policy through this guidance," which is "an affront to due process, an affront to the rule of law and an affront to basic fairness."

More than two years later, lawmakers responded with the passage of a bill in the House of Representatives, the Reforming CFPB Indirect Auto Financing Guidance Act. H.R. 1737 would nullify Bulletin 2013-02 and would require that the Bureau conduct a formal notice and comment period before it can issue any new guidance on the issue.

Pursuant to the bill, any new guidance would have to make publicly available "all studies, data, methodologies, analyses, and other information" relied upon and be based on consultation with other federal agencies, including the Federal Trade Commission, the Department of Justice, and the Board of Governors of the Federal Reserve System. In addition, the CFPB would need to conduct a study of the proposed guidance's impact on consumers as well as women-owned, minority-owned, and small businesses.

The legislation passed by a voice vote of 332 to 96 in the House of Representatives.

Now being considered in the Senate, the measure faces an opponent in the White House. "The Administration strongly opposes passage of H.R. 1737 because it would revoke important guidance designed to prevent discriminatory pricing of auto loans," according to the White House Statement of Administrative Policy. "The bill would create confusion about the existing protections in place to prevent discriminatory auto loan pricing, and effectively block CFPB from issuing related guidance in the near-term."

The same day, lawmakers took action against another CFPB policy, this time with regard to mortgage lending. The Portfolio Lending and Mortgage Access Act, H.R. 1210, would amend the Truth in Lending Act (TILA) to establish a safe harbor for depository institutions making residential mortgage loans held in portfolios to avoid certain requirements. For example, loans that appear on a depository institution's balance sheet could be treated as a Qualified Mortgage (QM) subject to certain limitations and could be able to take advantage of the Ability-to-Repay Rule's safe harbor.

By a vote of 255 to 174, the House passed the legislation and sent it to the Senate.

Again, the White House spoke out against the bill. "The Administration strongly opposes this bill because it would undermine critical consumer protections by exempting all depository financial institutions, large and small, from QM standards—including very basic standards like verifying a consumer's income—as long as the mortgage loans in question are held in portfolio by the institution. This bill would undermine the essential protections provided under the Qualified Mortgage rule," the White House said. "For these reasons, if the President were presented with H.R. 1210, his senior advisors would recommend that he veto the bill."

To read H.R. 1737, click here.

To read the White House statement about H.R. 1737, click here.

To read H.R. 1210, click here.

To read the White House statement about H.R. 1210, click here.

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Fed Governor Brings Shadow Banking Into the Light

Why it matters

In addressing the impact of the so-called shadow banking industry with the financial markets, Daniel K. Tarullo, a member of the Board of Governors of the Federal Reserve System, advocated for regulation of the industry based on the nature of the financial activity involved. The "constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors," as Tarullo defined the industry, requires regulation based on the specific benefits and risks of the given activity, and not on whether the activity looks like something banks traditionally do, he recently told an audience at the Brookings Institution. Nonbank lenders may be better positioned to offer financial services to consumers that banks cannot, while other nonbank intermediaries can expand the availability of capital—benefits that may outweigh some of the risks, Tarullo explained. Considering the possibility of regulation, he considered what form it should take and which regulator should make the necessary risk-benefit analysis.

Detailed discussion

Should the shadow banking industry be regulated? And if so, how? One of the lessons from the financial crisis was the major vulnerability of the shadow banking system and the extent to which such activities were not subject to prudential regulations integrated with the regulated banking sector, Tarullo explained. While many steps have been taken to address the causes of the financial crisis and specific forms of shadow banking. "[T]he answer to the question … of whether we are safer than before the crisis is easy to answer in the affirmative," Tarullo told his audience. "Of course, 'safer' does not necessarily mean safe enough."

Although the circumstances are different, the possibility of other systemic or risk related problems with shadow banking remains. Defining the industry as "a constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors," Tarullo said the very rigor of post-crisis reforms may create new opportunities within the shadow banking industry.

And yet, he appears to caution against moving too quickly or drastically against the industry, advocating for a balanced perspective. To do that, he emphasized three points, beginning with the premise that "it is essential to disaggregate the various activities that fall under the loose term shadow banking and to assess the risks and benefits they present on a discrete basis." Also, "notwithstanding the manifold nature of nonbank intermediation, it remains useful to identify the relationship of specific activities to the prudentially regulated sector," and "institutional considerations will be important in defining the potential, and actual, regulatory responses to nonbank intermediation."

Tarullo acknowledged misgivings about the use of the term "shadow banking," contending that it is both over- and under-inclusive of actual risks to financial stability. Recognizing the varieties of nonbank intermediation "reinforces the importance of assessing specific risks rather than merely categorizing activities as either shadow banking or something else," he explained.

As the risks associated with specific forms of nonbank intermediation are evaluated, he reiterated the importance of bearing in mind the specific economic benefit of the activities, such as increasing the diversity of the economy's capital providers and providing credit to borrowers that are underserved or unserved by traditional banks.

"It could be argued that one example of such nonbank activity is online marketplace lending, that uses new sources of data and new technologies to lower the fixed costs of making credit decisions, rendering lending to some individuals and small businesses more cost-effective," Tarullo said. "Of course, it matters a great deal whether this competition to traditional banks arises because risks are genuinely lower or useful new products have been created, on the one hand, or because well-grounded prudential or consumer regulations have been successfully avoided, on the other."

Assessing whether regulation is appropriate for specific forms of nonbank intermediation "requires a balancing of the resulting increase in socially beneficial credit, capital, or savings options against any associated increase in risks to the safety and stability of the financial system as a whole," Tarullo said. "The chief relevant factors to consider include the extent of reliance on maturity or liquidity transformation, the creation of cash equivalent assets, the use of leverage, and the degree of interconnection with the traditional banking sector."

He noted that when nonbank intermediation reflects a migration of traditional banking activities to less regulated entities, additional considerations may be necessary. Does the activity entail reliance on leverage or maturity or liquidity transformation that could lead to a bank-like creditor-run dynamic, are banks still informally or indirectly at risk, and is the activity migrating from systemic or smaller banks are all relevant questions, Tarullo told listeners.

If the activity at issue has "significant synergies" with core banking activities, migration out of the traditional banking sector could damage the efficiency of banks and increase their vulnerability, he warned. Alternatively, migration may be of less concern where banks have historically done a poor job of managing the risks of the activity.

Tarullo added that although he favors the specific risk and benefit analysis for nonbank intermediaries, he also believes "that the greatest risks to financial stability are the funding runs and asset fire sales associated with reliance on short-term wholesale funding." Though the total amount of short-term wholesale funding is lower today than precrisis, the volume is still large relative to the size of the financial system.

Measures by the Board to address the issue—such as the finalized liquidity coverage ratio—do nothing to address the risks of short-term wholesale funding by nonbank intermediaries, he said. "While it would be inadvisable to apply bank-style regulation to all entities that make use of short-term wholesale funding, a degree of consistent regulatory treatment is desirable to address bank-like risks in the shadow banking sector and to forestall regulatory arbitrage," Tarullo said. Consistent with that position, he said the Board will be developing a regulation that would establish "minimum haircuts for securities financing transactions (SFTs) on a market-wide basis, rather than just for specific classes of market participants."

Finally, Tarullo turned to two institutional considerations: what form of regulation is appropriate once analysis suggests that a response is needed and the question of which regulators would make the assessment and policy decisions.

Designation by the Financial Stability Oversight Council of nonbanks as systemically important institutions places some firms under the supervision of the Federal Reserve Board, he noted. However, with the "vast majority" of firms engaged in such activities not satisfying the statutory test for designation, Tarullo pushed for a tool targeted to actual risks: prudential market regulation.

"[A] policy framework that builds on the traditional investor-protection and market-functioning aims of market regulation by incorporating a system-wide financial stability perspective" would "take into account such considerations as system-wide demands on liquidity during stress periods and correlated risks that could exacerbate liquidity, redemption, or fire sale pressures," he said, using the example of SFT minimum haircuts.

As for which regulator should make the call, the natural answer would be "the regulator with authority to act," Tarullo said, although that raises potential issues of regulators relaxing regulations for their firms to create disadvantages for firms in a different sector.

While the growth of shadow banking in recent years has been relatively modest, "the grace period we are now experiencing may not last forever," Tarullo concluded. "New forms of intermediation may carry new risks, or older forms may acquire new risks as they expand and adapt to new circumstances. If we are to pursue a policy of case-by-case assessment that permits healthy forms of nonbank intermediation while protecting the financial system, financial regulators will need to develop effective and supple mechanisms for what I have termed prudential market regulation."

To read Tarullo's prepared remarks, click here.

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