REGULATING ONLINE MARKETPLACE LENDING: TO BE A BANK OR NOT TO BE A BANK?

• Author: Shulman, Jacob Gregory

1. Introduction 163 II. History and Development of Online Lending Practices 166 III Market Demand for Credit and Current Regulatory Scheme 169 IV. Market-to-Market Analysis 178 V. Special Purpose Charters 185 VI. Conclusion 190 I. INTRODUCTION

   The United States Treasury Department defines Online marketplace lending as the "segment of the financial services industry that uses investment capital and data-driven online platforms [featuring algorithmic underwriting models to] lend either directly or indirectly to consumers and small businesses." (1) In other words, "[m]arketplace lending is the process of connecting non-originator loan investors [, such as individuals and non-traditional investors,] with borrowers." (2) Marketplace Lending benefits lenders and borrowers by extending "credit to a broader range of borrowers." (3) Marketplace lenders are currently "less encumbered by rules," thereby "minimizing compliance costs" and allowing for more efficient loan processing than traditional bank lending. (4) Lack of regulatory oversight has led to a "proliferation of new companies and new product offerings" which provide capital to numerous small businesses and consumers, but is not without any consequences. (5) This note will explore the regulatory framework developing around marketplace lending.

   On May 10, 2016, the United States Treasury Department released its white paper on online marketplace lending, "Opportunities and Challenges in Online Marketplace Lending." (6) The emerging market of marketplace lending gives unprecedented access to funding on behalf of consumers, students, and small businesses because the "low-cost operating model for platforms which allows for lower rates for borrowers as well as solid returns for investors." (7) Now, these lenders offer "small business loans, education loans, and health care finance loans." (8) The Supreme Court of the United States denied certiorari to Marketplace Lending cases in 2015 and 2016, and has not since considered any Marketplace Lending case, exposing Marketplace Lending to uncertainty and risk due to varying circuit cases. (9)

   Although there are many facets of, and regulatory problems (10) with, online marketplace lending, this article will evaluate regulatory proposals and concerns of Online Marketplace platforms for small and medium-sized enterprises ("SMEs"). This article will not address Regulation Crowdfunding, (11) nor regulatory concerns with peer-to-peer lending generally. Part II will explain the historical progression of peer-to-peer lending to modern day marketplace lending. Part III will explore the market demand for credit and analyze the current proposed regulatory scheme. Part IV will provide a market-to-market analysis of marketplace lending from economic and regulatory viewpoints. Part V will address special purpose charters provided by the Office of the Comptroller of Currency ("OCC").

2. HISTORY AND DEVELOPMENT OF ONLINE LENDING PRACTICES

   Marketplace lending began with individuals providing capital to other individuals in what is a "'peer-to-peer' model". (12) Marketplace lending now encompasses more complex entities such as "funding by institutional investors,... hedge funds, banks, and insurance companies, seeking to provide financing that ultimately is used to fund consumer and small business loans of various types in order to gain access to additional lending channels and favorable rates of return." (13) Additionally, "[m]arketplace lenders also use public offerings, venture capital, securitizations, and loans from banks as funding sources." (14) Despite the recent rapid growth, "marketplace lending remains a relatively small part of the $3.3 trillion U.S. consumer lending market." (15) Moreover, "marketplace lending is an emerging way to extend credit using algorithmic underwriting which has not been tested during a business cycle, so there is a risk that marketplace loan investors may prove to be less willing than other types of creditors to fund new lending during times of stress." (16)

   Independent Community Bankers of America, the national association for small banks, wants government review of "the relationships between marketplace lenders and the banks that often issue their loans, as well as the establishment of a primary regulator for the peer-to-peer loan industry." (17) In fact, similar financial innovators,

   similar to these online marketplace lending platforms always promise attractive returns for investors while providing liquidity to grow small business in underserved and emerging markets," the small-bank trade group wrote. "However, these ventures never contemplate economic recessions, hardships and the impact of deteriorating economic conditions on a borrower's ability to appropriately manage a loan contract that he or she has limited ability to understand. (18) "[U]p to 60%of total employment... in emerging economies" are in SMEs. (19) "SMEs are less likely to be able to [secure] bank loans than large firms; instead, they rely on internal [or 'personal'] funds to launch and initially run their enterprises." (20) Around fifty percent of SMEs "don't have access to formal credit." (21) The credit gap in the SME Sector is roughly one trillion dollars. (22)

   The trillion dollar gap is an unserviced demand for credit. (23) Online Marketplace Lending "best describes the many fast-growing firms using [financial] technology ['FinTech'] to build online platforms that stand between borrowers and lenders." (24) FinTech is composed of companies that use technology to make financial systems and the delivery of financial services more efficient. (25) Banks as well as other institutional investors invest in, partner with, and launch FinTech companies and solutions. (26) Banks partner with FinTech companies in order to originate loans for FinTech lenders and expedite loan servicing. (27) FinTech presents many opportunities including enhanced operational efficiency and improved consumer experience, but there are also risks, such as strategic, compliance, credit, operational, and data security risks among others. (28) "Risks for Original Creditors" include regulatory risk, reputation risk, litigation risk, and risk retention. (29) "Risks for Marketplace Platforms" include funding risks, data breaches, and borrower fraud. (30) "Risks for Investors" include insolvency risk, fraud or mismanagement risk, servicing risk, loss of collateral, verification risk, custodial risk, documentation risk, and repurchase risks. (31) Warehouse Lenders risk collateral deterioration and borrowing entity risk. (32) Rating Agencies also have reputational and fraud risks. (33)

   On January 13, 2017, The White House released "A Framework for FinTech" (34) based on initial insights gained after the White House FinTech Summit held in June. (35) In short, the White House states "[s]ignificant work remains" and that "policymakers, regulators, and the private sector should continue engaging with one another to foster innovation in fintech while protecting consumers and the financial system." (36)

   Marketplace lenders, among other FinTech companies the report opines,

   play an important role in serving creditworthy borrowers and businesses in need of capital... [by] improv[ing] access to safe, affordable and fair capital to help individuals and small businesses take control of their finances while supporting sustainable economic growth. This [Obama] Administration recognizes the importance of... access to capital. (37) Thus, a regulatory framework needs to be crafted which promotes marketplace lending, while protecting consumers.

3. MARKET DEMAND FOR CREDIT AND CURRENT REGULATORY SCHEME

   Peer-to-peer lending developed to fill a void in the consumer lending market. (38) The void filled by "P2P lending" is bridged when "the gap between consumers who need a loan and consumers... who have the money to back them." (39)

   There are many ways that marketplace lenders fund their operations, "including through public offerings, venture capital, loans from banks, and peer-to-peer lending, where individual--usually retail--investors provide funding to individual borrowers." (40) As of recent, "whole loan sales to institutional investors and the securitization market in particular have become an increasingly important source of term funding." (41) This business model is known as the "Platform Lender Model". (42) Platform lenders partner with depository institutions which originate the loans ("origination"). (43) Conversely, the "direct lender model," also known as "Warehouse Loans," is used by "balance sheet lenders," where the lender "originate[s] loans [for] their own portfolios." (44)

   Two of the largest online platforms are Prosper and LendingClub, who offer investors the opportunity to fund third party's unsecured, non-recourse loan. (45) The lenders, on both sites, can view information about the borrower, including the borrower's loan purpose, credit history, and other limited data. For example, Michael Mazier, a veteran in the marketplace lending and blockchain areas, believes there is not enough transparency for secondary market investors to make an optimal investment decision because of privacy laws. (46)

   Generally speaking, there are "three methods for funding a loan": by deposits, by a balance sheet, and by investors. (47) Loans funded by deposits are traditional bank loans. (48) Loans funded by a balance sheet are operated by "a loan origination company." (49) Loans "funded by investors who are not related to the originator... take on financial risks and rewards of loans." (50) Risk is diversified if a loan is funded by investors and facilitated by intermediaries, like Web-Bank loans (utilized by Lending Club and Prosper). (51)

   Marketplace Lenders are usually funded by investors, but some also funded by the balance sheet of a loan origination company. (52) However, "the Marketplace Lending Association assigns an upper ceiling of 25% of origination on balance...