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August 26, 2013
Caution, Online Payday Lender Ahead
Payday lenders offer consumers short-term unsecured loans with high fees and interest rates. Payday loans—also referred to as deposit advance loans or payday advances—are a form of credit that some consumers may find appealing for a number of reasons, including an inability to qualify for other credit sources. The borrower usually pays the loan back on the next payday—hence the term "payday loan"—which means the underwriting process typically includes a history of payroll and related employment records.
A growing number of payday lenders operate their businesses virtually. Consumers can obtain loans and authorize repayment of the loans and fees during the same online session. In a typical online payday loan scenario, a borrower obtains a loan and provides authorization for the lender to send Automated Clearing House (ACH) debits to the consumer's account at a later date for repayment. The payday lender's bank can originate the debits through the ACH network. Wire transfer and remotely created checks may be other payment options.
Both state and federal regulators are currently focusing on the payday lending industry to protect consumers from illegal payday loans. Payday lending practices are usually regulated on the state level. Some states prohibit payday lending, while others require lenders to be licensed and to comply with maximum fees, loan amounts, and interest rate caps, among other restrictions. On the federal level, the Dodd-Frank Act has given the Consumer Financial Protection Bureau the authority to address deceptive and abusive practices by payday lenders.
Payday lenders' banks should consider all the risks involved with working with online payday lenders. And they should make sure to incorporate due diligence techniques and to become familiar with the available tools.
Reputation, reputation, reputation
First, there is reputational risk. A payday lender's bank should be aware that a business relationship—including ACH origination activity—with a company making illegal payday loans can damage the bank's image. Reputation can suffer even if the bank is not complicit in the illegal activities of its payday lender customer. But once a financial institution determines that facilitating payments on behalf of online payday lenders falls within its risk management model, it should ensure compliance with applicable laws and regulations. Providing periodic reports on ACH customers to the bank's board of directors is one way to facilitate review of whether these customers' activities remain within the bank's risk management model. It is critical that the bank protect its reputation, as that affects every part of its business.
The importance of know-your-customer practices
The payday lender's bank should also develop and follow adequate due diligence procedures. ACH rules require—and regulatory guidance advises—that banks perform "know your customer" (KYC) due diligence. KYC includes a variety of activities such as assessing the nature of the online payday lender's activities, setting appropriate restrictions on the types of entries and exposure limits for the lender, and monitoring origination and return activity.
Due diligence steps can include: 1) identifying the business's principal owners, 2) reviewing ratings for the business from the Better Business Bureau, consumer complaint sites, and credit service companies, and 3) determining if there have been recent legal actions against the business. A thoughtful review of the lender's website, including the terms of the consumer's authorization agreement as well as promotional materials, is advised. These due diligence practices during onboarding and on an ongoing basis for all merchants—including online payday lenders—help the bank with setting and enforcing appropriate restrictions for the customer and therefore mitigate the risk of the bank discovering a problem when it is too late.
Mitigating problems by being proactive
Banks can develop tools that flag potential problems in-house or obtain them from vendors, ACH operators, or NACHA. In addition, incorporating a process to monitor transactions and returns to identify anomalies can be very useful. An anomaly could, for example, be a sudden uptick in returns or an unusual increase in origination volume or average dollar amount. Detecting anomalies can be a trigger to conduct further research with a customer.
Other tools can be NACHA's originator watch list and vendor-terminated originator databases, which can help banks identify customers that may warrant additional scrutiny. Periodic audits can also be a useful tool to identify rules compliance issues.
For a bank, protecting its reputation is paramount when it is considering offering payment services to high-risk originators like online payday lenders. It should exercise caution, performing risk-based due diligence on new customers and then diligently monitoring current customers so it can identify problems early and address them proactively.
By Deborah Shaw, a payments risk expert in the Retail Payments Risk Forum at the Atlanta Fed
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