Canada: New York State Department Of Financial Services Issues Report On Online Lending

The New York State Department of Financial Services ("NYDFS") has recently issued an Online Lending Report (the "Report") analyzing current consumer and legal issues relating to online lending based on survey results and state records.

The Report details the analysis of survey results from 35 institutions believed to engage in online lending activities in New York, out of 48 institutions solicited. In addition, the Report also references other state reports and legal records to contextualize survey results. However, the Report notes its findings are limited by a small sample size, low response rate and fragmented quality of the responses.

Access to Credit

Survey results suggest that online lending has had positive effect on access to credit. In 2017, over 235,320 borrowers received 352,171 loans in the State of New York, with loan amounts totalling almost $3 billion. Over $500 million was extended to 78,611 borrowers that were unbanked or underbanked. Survey responses also suggest expanded access to credit by microbusinesses and businesses in disadvantaged and financially underserved communities.

Business Model

The Report finds that, as online lenders are generally not deposit-taking institutions, their funding sources may be limited.  Online lenders tend to adopt an "originate-to-distribute" business model and sell a majority of their receivables as securities in order to generate timely revenue to sustain operations.

The Report notes there are risks associated with the originate-to-distribute model. Such model can disincentivize the proper screening of loans, as online lenders stand to profit as long as investors are purchasing debt securities, regardless of whether they turn out to be delinquent (i.e. they do not have any "skin in the game"). Start-up lenders can be particularly vulnerable to the risks relating to the use of the originate-to-distribute business model given their more limited resources. Large, diversified institutional lenders are generally deterred from engaging in risky lending practices given their larger operating assets base and wider exposure to negative externalities resulting from such practices.

Credit Assessment Methodologies

The Report found that online lenders are using fragmented credit assessment methodologies. According to the Report, online lenders tend to use different combinations of internal and outsourced assessment models. They do not have access to a uniform source of external data, using data sources ranging from credit bureaus to LexisNexis to social media. In addition, the Report notes there did not appear to be an objective criteria used by online lenders in  calculating loan loss reserves. The more relaxed standard of credit assessment could generate inaccurate credit results and ultimately contribute to higher delinquency rates.  The Consumer Financial Protection Bureau has also been consulting on the use of alternative credit data

Borrower Disclosure

According to the Report, certain online lenders also manipulated disclosure materials in order  to attract borrowers. For example, an online lender offered financial products consisting of upfront lump sum payments for pensioners' pension receivables. This lender misrepresented the nature of the products to potential customers by marketing them as sales rather than loans. The online lender also did not disclose illegal interests rates and service fees. Other lenders also manipulated product marketing in order to extend loans without proper licensing.

Extra-Jurisdictional Operations

In the US, usury rates are regulated at the state level in the case of non-national bank lenders.  The Report suggests that online lenders may be structuring themselves to avoid New York law restrictions on interest rates, either by using out of state offices to lend to New York residents or by partnering with out-of-state or federal banks. The Report suggests in some cases the partnerships may be largely nominal with online lenders maintaining control over all operational activities from marketing to collection.

The 2015 ruling Madden v. Midland Funding, LLC ("Madden") by the Second Circuit Court of Appeals in New York questioned the "valid when made" common law doctrine in the U.S. which stands for the proposition that when a loan agreement is valid when it is made it cannot be invalidated by any subsequent transfer to a third party, including for state usury laws for interest rates for loans issued by a national bank.  Commentators have criticized the Madden decision for undermining certainty for the assignment of loans.  In a recent report, the U.S. Department of the Treasury noted that Madden may discourage online lenders from purchasing and attempting to collect on, sell or securitize loans made in certain jurisdictions in order to avoid litigation risk with borrowers ascertaining violations of state usury laws. As a result, some online and marketplace lenders have changed their business activities by, for example, excluding loans with borrowers from New York and Connecticut from their pools of loans.

Implications for Canada

Online lending is less prevalent in Canada, but has been growing, having grown for example from US$8 million in 2013 to US$71 million in 2015, according to a recent report on Fintech credit platforms issued by the Financial Stability Board and the Committee on the Global Financial System. 

Some of the concerns raised by the NYDFS are not relevant in Canada.  In particular, in Canada, criminal rates of interest are regulated at the federal level under the Criminal Code rather than at the provincial level, and all entities are subject to the same cap, meaning the concerns raised in Madden would not be directly relevant in the same way to Canadian online lenders.

There is no public data available at this time in respect of the use of credit assessment methodologies by online lenders in Canada.  However, provincial credit reporting legislation would apply (regardless of the type of lender involved) to the extent credit information is being obtained and/or used. 

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