Online Lending And A Tale Of Two Fed Studies

Online consumer lending – in a variety of forms – has grown explosively over the last decade. In 2010, digital lenders originated $249 million in unsecured personal loans, and by 2016 that number had grown ninety-fold.

But as online lending has become an increasingly important part of the financial services landscape, the topic has generated no shortage of debates over everything from its business models to the customers it attracts and the method used to acquire them.

The recent release of a study by the Cleveland Federal Reserve has managed to increase the decibel level of that debate. Its team of economists takes a rather dim view of the online lending space and the ways in which it recruits and handles its customers – and believes that additional regulation is needed to rein in some of the excesses their research uncovered.

These conclusions are diametrically opposed to those released jointly just a few months ago by the Chicago and Philadelphia Fed economists, who determined that online lenders serve those who are systemically underserved by traditional financial channels and benefit greatly from their services.

So how did one branch of the Fed end up on such a different page from their counterparts?

Cleveland’s Dark Outlook

The Cleveland Federal Reserve Bank captured a lot of headlines with the release of its online lending study – particularly due to its use of the words “predatory” and “needs additional regulation.”

The study examined data from TransUnion that identified about 90,000 customers who had taken out an online loan between 2007 and 2012. Using statistical techniques, those 90,000 customers were matched against a similar number of borrowers who were otherwise similar in income, credit history, initial borrowing power and other demographic details, but who did not use online loans. The data found that customers who had taken out online loans had grown their debts 35 percent more than those who had not, over a period of two years.

That detail alone isn’t necessarily bad news – after all, having more debt doesn’t necessarily mean the online lending customers are doing worse. But paired with other data, the news looks pretty grim. According to the Cleveland Fed survey, the online lending customers also showed lower credit scores on average, more delinquent debt and more total debt outstanding.

The findings further suggest that in some cases, the three- to five-year installment loans of up to $30,000 to $40,000 often offered by online lending sites are not being used for their intended purpose of consolidating credit card debt into a single, lower-interest loan. Instead, customers were using those loans to rack up more debt and maxing out the cards they used to pay off the loans.

“[These borrowers] are not underbanked, they’re sort of overbanked,” observed Yuliya Demyanyk, a Cleveland Fed economist who co-authored the research, of the typical borrower making use of an online lending site.

Moreover, Demyanyk noted, these loans looked weaker, not stronger, over time, something that she feels is déjà vu all over again.

“Defaults on [marketplace] loans have been increasing at an alarming rate, resembling pre-2007 crisis increases in sub-prime mortgage defaults, where loans of each vintage perform worse than those of prior origination years,” she said,

Moreover, the Cleveland Fed found that though “better interest rates” are an often-advertised benefit of online loans, only prime and super-prime borrowers actually enjoy that benefit. Those in riskier groups were not getting noticeably better rates, and in some cases, were actually paying more in interest.

The verdict?

“[Online] loans resemble predatory loans in terms of the segment of the consumer market they serve and their impact on consumers’ finances,” the Cleveland Fed team concluded. “Given that [online] lenders are not regulated or supervised for anti-predatory laws, lawmakers and regulators may need to revisit their position on online lending marketplaces.”

Philly, Chicago And A Very Different Result

When the Philly and Chicago Fed released the results of their marketplace lending study in July, they reported very different results.

“[Online lender] technology platforms and their ability to use non-traditional alternative information sources to collect soft information about creditworthiness may provide significant value to consumers and small business owners, especially for those with little or no credit history, the Philadelphia/Chicago report noted. “In addition, as more millennials make up the pool of small business owners and the consumer population, they are more comfortable with technology, and therefore may be more comfortable dealing with an online lender than a traditional bank.”

The earlier report did note that outcomes varied depending on the specific borrower profile and their precise lending requirements. However, because of the expanded and more inclusive credit ranking criteria, consumers who might otherwise be “credit invisible” or appear to have a sub-prime score are able to get a more complete evaluation that considers a wider array of factors. Those alternate evaluation criteria, they say, offers potential for access in a credit market that has become tighter and on the whole less accessible for both consumers and small businesses since 2007.

The economists from the Philly and Chicago Feds did note that the lack of regulatory scrutiny in marketplace lending meant the space could have some fairly worrisome issues.

The lack of regulatory clarity raises concerns, they said, over whether customers are treated fairly, have “equal access to credit, and receive offers that can be easily compared and understood,” suggesting that alt lenders need to compete on a level playing field with their regulated bank counterparts.

However, the Philly and Chicago team concluded that – when measured by the standards of access, pricing and use of alternative data sources to give more consumers fair access to credit – online lenders deliver.

Why The Discrepancy?

So how did three different groups of economists look at the same segment and come away with such different conclusions? A large chunk of the discrepancies comes from the fact that they really weren’t looking at the same things at all.

The Cleveland Fed study examined data from TransUnion for consumers who had been identified as having taken out “online bank-based loans.” That includes a much wider set of businesses and lenders than is technically defined by the more traditional online lenders.

The Philly-Chicago study focused entirely on data from Lending Club, a marketplace lender. Critics of the more upbeat Philly-Chicago study argue that it’s too specific a base to draw general conclusions about the whole of marketplace lending.

So, what is the takeaway?

While much has been made of the places where the two surveys disagree, little has been said about the main point of agreement between both: The segment is growing rapidly and it needs more regulatory oversight.