The small-business lending market has grown considerably in the past decade. Following the Great Recession, banks had, for a time, essentially stopped lending to small businesses.
Recognizing the underserved market, online lenders popped up and decided that they'd lend to these more "risky" borrowers. Sure, online lenders charge higher rates in exchange for the increased risk they incur, but businesses still deem those loans to be useful to help grow their businesses.
However, federal regulations have been slow to keep up with this quickly changing environment. Many have accused online lenders of taking advantage of lax rules and imposing fees and rates that are too unclear to borrowers.
In July of this year, the Office of the Comptroller of the Currency (OCC) made available a national bank charter specifically for fintech companies and invited online lenders to apply. This move spans well beyond small-business loans, but it has a large effect on the industry specifically because one of the intended benefits of the charter is to bring standardized and tougher regulations.
The announcement of the charter has been polarizing. Some view it as beneficial because of the increased regulation and the potential for direct competition between online lenders and banks. Others view it as unnecessary and argue that small-business loans should be controlled at the state level.
We had the chance to speak with Professor Chester S. Spatt, professor at Carnegie Mellon University’s Tepper School of Business and visiting professor at MIT’s Sloan School of Management, about the issue and to get his view on how this would affect both borrowers and lenders as a whole.
This interview has been condensed and edited for clarity. If you're a small-business owner interested in sharing your funding story, tweet us at @ValuePenguin.
Can you talk a little bit more about your background?
Sure. I served as Chief Economist at the SEC from 2004 to 2007; in that context I certainly was fully exposed to the broad set of capital market regulatory issues. I've also closely observed the aftermath of the evolution of our financial markets subsequent to the financial crisis, and I’ve been a close observer of financial regulation since then. I’m a professor at Carnegie Mellon University’s Tepper School of Business, and I’m currently on leave as a visiting professor at MIT’s Sloan School of Management.
Many would say that the small-business lending space has been operating without strict regulations for quite some time and that's one reason the OCC launched a new national fintech bank charter. Do you think this is the right response by the federal government?
I’m not sure it is the right response at this point. The underlying problem, in my mind, is a chicken-and-egg problem. I’m concerned at a few levels. Context wise, we’re really still sorting out as to what the right models are with the mix of online and traditional lenders. Of course, there are issues like the rent-a-bank model that some online banks use, but is it such a major issue that it requires uniformity? That’s obviously what federal preemption does.
It's challenging because online lenders have a different approach to lending. Just because a lender operates online or sets itself up in the fintech space, does that necessarily obviate the need for some of our traditional regulations? It’s not really that clear. In my mind, lending is lending.
We also have the issue of innovation. The innovators, they would like to know what the regulations are so they can figure out how they want to be regulated, or whom they want to be regulated by. That’s understandable enough. But then, the appropriate regulations depend on what kinds of businesses we’re talking about and how they’re structured. Basically, it’s simply an issue of the federal government going out there with a really definitive set of rules … I can see why this could be a bit of a problem given that we don’t know so much yet about this space. I think that’s a real challenge. The main types of issues that I see are: What’s the connection between federal versus state regulation? Should we have preemption? Did we otherwise have uniformity? Maybe to some extent we did, although it might have been “a race to the bottom.”
I also have thought about these issues somewhat, also in the context of some of the fintech ventures from the security market space. To what extent should initial coin offerings be treated as securities, for example? There’s this feeling out there that we should promote innovation. That’s all fine and good, but if the initial coin offerings are basically like an IPO, then there’s a real fundamental question: Why should we regulate them differently? I’m not saying that a regulatory structure needs to be rigid and for all time. Maybe that’s some of the difficulty: that once the regulators lay out what they view as permissible, then everybody is going to operate to push the envelope as far as they can. But how would we get to a more dynamic system of regulation that’s not simply the standard regulatory model?
The OCC made this charter to supposedly help the industry grow. Have you seen a case where regulations have been significantly beneficial or detrimental?
This problem of how the government should regulate these fintech companies is very new. In a way, there’s a whole set of issues across the markets: It’s showing up now in insurance, it’s showing up in capital markets and securities, too.
Let's use one example from the capital markets space as an example. One similar situation that I'm very familiar with is the mutual fund model, and to some degree, it's been a challenge for two decades or so. Some would say that mutual funds are thriving and that they're more important than ever. There's some truth to that since a lot of people now have moved away from homemade portfolios. But exchange-traded funds have really challenged mutual funds over recent years. Over the last 20 years the business has changed dramatically and traded funds have become very important.
It's a relatively sudden onset of new financial products, similar to loans from fintech lenders, and the SEC had to figure out how to regulate them. Well, in my opinion they're still figuring it out. The SEC has partially figured out how to scope them into the mutual fund regulatory structure under the Investment Company Act but, at the same time, many of these products need to go through the SEC to get what’s called “exemptive relief.” So if a product goes through that, the SEC agrees that it won’t bring an enforcement case against them.
At that point it’s saying, the rules are ambiguous as to whether a particular set of practices are allowed in setting up exchange-traded funds, but we’re going to exempt you from that. In a way, it combines different elements of this. Because, it’s not quite saying: OK, here are the rules forever. Instead it’s saying: We have this framework, we have this set of rules, but we know a lot of them are going to have to be, in effect, litigated; not formally litigated, but we’re going to have to use the facts and circumstances of particular situations to make decisions. I think that, at least, does provide some degree of flexibility. Now, it’s also a frustrating approach to practitioners sometimes, because one of the complaints about the approach is it can take a long time to get a determination.
One possible consequence of the new charter is ceilings on what lenders can charge. How do you feel about that?
I'm really not a fan of interest rate ceilings or the usury laws in different states and I don't particularly believe in them. Why is that? Because I think the payday lenders are performing a social function. Right or wrong, some folks in our society from time to time need access to that type of funding, despite the very high interest rates and fees.
I’m actually not a fan of minimum wage laws either. If they’re not binding it’s not such a big deal, but if they’re binding, I worry that it interferes with employment. In the case of minimum wage laws, the argument is made as to how can somebody support a family based on the minimum wage? I think the reality is, if somebody’s productivity is only at a certain level, do we bar them from obtaining gainful employment? Furthermore, the reality is, most of the people who would be constrained would be teenagers who are looking to help their families and supplement their family incomes. And just to prevent their employment, this seems to me to be problematic. What it does is encourage employers to substitute capital, and not have so many employees.
Or, a different example: I find it anathema that, not so many, but a few jurisdictions have or have had rent control laws. It seems to me, what we want to do is encourage demand and supply to adjust. If you have artificial ceilings, the people who are already entrenched in the property are going to tend to not be efficient users of the property. So, in general, I think there are a lot of distortions that come from these types of rules. That being said, the states have these rules, and if a state wants to undercut itself by having these rules, should we necessarily just bar it by providing a federal charter? Not so clear to me.
Can you expand a bit more on the necessity for things like payday loans?
I wouldn’t say they’re unethical. I don’t think it’s like theft, for example. I’m not sure there are necessarily lots of excess returns. If there were, you’d expect to see lots of competition in providing these services. There obviously must be a lot of costs and a lot of default. So I wouldn’t say payday lenders are inherently unethical. Some politicians would say that. I don’t think there’s much of an economic foundation for that. I think it’s poor communities that are wronged by bars on payday lending.
Now it’s not that I would encourage people to use payday lenders — far from it! I wouldn’t encourage people to use payday lenders. I would encourage people to try to organize their lives in such a way that they have enough internal resources that they can occasionally do the payday loans among themselves, if they need to. So that they have at least a little bit of liquidity, because that little bit of liquidity is very valuable, as we can see from the payday loans. But if the rates are made clear and people are still taking out those kinds of expensive loans, I would say let them, since there is obviously a need for them.
If they're being unclear about rates and fees, then that's a different story.