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Use of Alternative Data in Underwriting Receives ‘OK’ from Federal Regulators

December 5, 2019

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On Tuesday, December 3, 2019, U.S. federal banking regulators issued an interagency statement supporting the evaluation of alternative data when assessing consumers’ creditworthiness. Recognizing that the use of alternative data may improve the speed and accuracy of credit decisions, the agencies hope to address the difficulty facing consumers who are often unable to obtain credit from traditional credit sources. According to FinRegLab, a nonprofit research organization, an estimated 45 million to 60 million consumers lack the credit history needed to generate satisfactory credit scores. Further, millions more do not have access to affordable credit due to low scores and low incomes. The use of alternative data in the rendering of credit decisions may improve credit opportunities, as firms may choose to use these alternatives for those applicants who would otherwise be denied credit.

One such data source is a borrower’s cash flow as an alternative to the traditional credit-evaluation system. Although not an entirely novel concept, and an already well-established part of the underwriting process, some firms are now automating the use of cash flow data to determine a borrower’s ability to repay loans. These newer automation methods have been found to improve the measurement of a borrower’s income and expenses. Most importantly, the automation of a borrower’s cash flow better illustrates income patterns over time from multiple sources as opposed to evaluating a single income source; the borrower information gleaned from these alternative sources is more robust and comprehensive than the information relied upon by traditional credit-evaluation companies. As the regulators highlight in their interagency statement, “cash flow data are specific to the borrowers and generally derived from reliable sources, such as bank account records, which may help ensure the data’s accuracy.”

To the extent firms are using or contemplating using alternative data, the agencies encourage responsible use of such consumer data. As the sources of alternative data grow, both banks and non-banks will need to determine which types of alternative data might carry more risk to consumers – and do their best to minimize or justify the use of such data sources. Although cash flow data provides a relatively unbiased predictor of loan repayment ability, some lenders have garnered fair lending scrutiny for their use of certain alternative data such as borrower occupation, education and information from social media. As the agencies made clear in their statement, lenders considering the use of alternative data must take steps to ensure consumer protection risks are “understood and addressed.” Accordingly, it will remain vitally important for lenders leveraging alternative data to do so within a well-developed fair and responsible lending program that includes, among other things, periodic fair lending testing.

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OCC and FDIC Clarify the “Valid When Made” Debate

November 22, 2019

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On November 18 and 19 of this week, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued Advanced Notices of Proposed Rulemaking (ANPRs) to clarify how state interest rate caps should apply when loans are sold across state lines.

Example of a Madden Glitch

The proposal from the OCC reaffirms the “valid when made” doctrine, on which many marketplace lenders have relied and which was central to the Second Circuit’s 2015 decision in Madden v. Midland Funding LLC, 786 F.3d 246 (2nd Cir. 2015). The Second Circuit’s decision contradicted the “valid when made” theory, whereby an obligation is considered valid under the law that applied at the time of origination. The Second Circuit held that a loan’s interest rate was no longer valid when resold to an entity in a state with a lower interest rate cap than where the loan was originally issued. In its proposed rule, the OCC “has concluded that when a bank sells, assigns, or otherwise transfers a loan, interest permissible prior to the transfer continues to be permissible following the transfer.” The OCC’s proposed rule would cut against Madden, allowing the interest rates attached to bank loans to remain valid once transferred to a bank’s fintech partner of investors.

The FDIC’s proposed rule parallels that of the OCC, but focuses on Madden’s relation to state-chartered banks. The FDIC’s proposed rule clarifies that the legal interest rate on a loan originated by a state bank remains legal even after the loan is sold to a non-bank. Speaking in a statement on Tuesday, FDIC Chairwoman Jelena McWilliams said “This proposed rule would correct the anomaly by establishing in regulations … that the permissibility of interest would be determined when a loan is made and is not impacted by subsequent assignment, sale, or transfer.” The draft regulations issued on Tuesday by the FDIC affirm that state banks are not bound by the interest rate caps of other states in which they operate. Further, the validity of the loans’ interest rates would be fixed at the time of origination.

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