PeerIQ leaders spent the week in Washington discussing the future of FinTech under a new regulatory regime.
In this “PeerIQ Goes to Washington” newsletter, we synthesize our findings from dozens of conversations with market regulators and industry participants. Specifically, we discuss the likely direction of SEC leadership, what to look for in the OCC charter, and legislation that may alter the financial regulatory landscape.
The SEC opened up the week with the FinTech Forum. Chair Mary Jo White’s opening comments acknowledged that marketplace lending is “providing individuals and small business with new paths to access capital” – sharing a key finding of the US Treasury.
Chair White made the case for more transparency to improve investor protection: “a key challenge is the adequacy of the information available to investors to make informed investment decisions, such as information about the loans and borrowers underlying their investments, as well as the platform’s proprietary risk and lending models.”
On the capital formation panel, in response to Sebastian Gomez’s (SEC Head of Office of Small Business Finance) opening question on what innovation is driving capital formation, PeerIQ CEO, Ram Ahluwalia, noted:
- Banks, facing stringent capital and liquidity rules, have tightened access to credit.
- Non-banks, using technology and customer experience innovation, are filling the lending gap. Remarkably over half of mortgages are now originated by non-banks, and non-bank lending continues to grow at a double digit pace across mortgages, auto, student, credit card, and installment loans.
- Securitization serves as the link connecting non-banks to the capital markets, and consequently, securitization is the primary financial innovation driving capital formation.
- Securitization is transforming illiquid credit to marketable securities that, in turn, enable a diverse, broad base of institutional investors to invest in the real economy. Indeed, of the $17 Tn in loans outstanding, approximately 50% are funded via securitization according to SIFMA.
- However, as a transmission mechanism, securitization remains fragile when investors lose confidence as in 2008, or as recently as Q1 ‘16.
- In a world where policy levers for growth are limited, policy makers and the public have a strong interest in encouraging an orderly securitization market to diversify sources of funding for the real economy.
- PeerIQ is doing its part by working with industry leaders and self-regulatory bodies such as SFIG to encourage standardization, transparency, and liquidity to promote the smooth functioning of the ABS markets.
The SEC Makes a Bid for Regulating FinTech
SEC Commissioner Piwowar remarked that the “Commission should take the lead regulatory role in the FinTech space,” noting that the SEC is the sole agency that explicitly includes capital formation as a mandate (among other rationale).
“As is obvious to any market participant or observer, our financial regulatory structure is a fragmented, sometimes contradictory, alphabet soup. A recent study by Georgetown University’s McDonough School of Business Center for Financial Markets Policy correctly points out that the most common regulatory struggle for FinTech firms in the United States ‘does not concern a specific regulation or regulator, but rather the extremely complex process of navigating multiple regulatory portals.’”
SEC Chair Candidates are Constructive on Securitization
SEC Commissioner Piwowar and former Commissioner Gallagher are rumored to be leading candidates for the next SEC Chair.
Based on public comments from both Commissioners, we would expect a shift in SEC policy from prescriptive risk management to a disclosure regime.
At ABS Vegas last year, Commissioner Piwowar cautioned on the potential for inappropriate regulation to stifle securitization and, by extension, credit extension:
“…we must keep in mind that unnecessary or inappropriate regulation of securitizations may lead to less availability of capital, increased borrowing rates, and a more limited supply of credit. These effects are likely to be passed on to borrowers, either in terms of increased borrowing costs or loss of access to credit, and thus will cut directly against the benefits of securitization.”
Piwowar also opposed the blunt, across-the-board 5% risk retention rule:
“Rather than carefully examining these attributes to determine an optimal credit risk retention rate for each asset class, prudential regulators in Washington, D.C., took the easy way out – they simply set it at the maximum statutory rate and ignored the authorization from Congress to create lower risk retention requirements or use alternative methods to align interests.”
Piwowar noted the “transformational impact” of FinTech and is also supportive of a regulatory sandbox, similar to models in the UK:
“FinTech is frequently lauded as a disruptive force that is transforming the financial services industry, and that is clearly true.. . .We should also explore various constructs that have been proposed, both domestically and internationally, to encourage FinTech innovations without creating undue risks to the marketplace or imposing artificial limits on activities (e.g., regulatory sandboxes).”
Another candidate floated for the Chair position is former Commissioner Daniel Gallagher. Gallagher would likely re-focus the SEC on equity market structure and corporate disclosure rules. Gallagher is also sharply critical of the Volcker rule and risk retention. Gallagher also is critical of the qualified mortgage rule which may be limiting the size of the mortgage market.
The Office of the Comptroller of the Currency (OCC) is a prudential supervisor that charters, regulates, and supervises all national banks and federal savings associations as well as federal branches. The OCC is an independent bureau of the U.S. Department of the Treasury.
The OCC is expected to publish a paper on a possible FinTech charter later this year. We can only guess at the contents of the OCC charter. Here are the core terms to look for:
The OCC may be able to issue a final rule before the end of Comptroller of the Currency Thomas Curry’s term in April, although timing will be tight. More likely, a Trump-appointed comptroller would pick up the issue.We observe that Peter Thiel, an active FinTech investor, is on the Trump transition team. Regulatory prognosticators see no reason why the subsequent Comptroller would oppose a charter.
Legislative Pendulum Swinging Back
We expect major banks, asset managers, and insurers to challenge the “systemically important designation” which places a capital surcharge on institutions deemed systemically important by FSOC.The following pieces of legislation are attracting attention in the FinTech and banking community.
Potential for Relaxing Capital and Liquidity Rules
As we noted in our March 2016 analysis, we believe current and pending capital and liquidity rules, particularly when combined, will have the negative effect of deterring banks from holding and making markets in ABS. Specifically:
- Tier 1 Capital ratio: Under Basel III, Tier 1 capital requirements for banks increase, with the new ratio for some large banks exceeding 10% of risk-weighted assets (RWAs).
- Differing RWA treatment: Currently, the risk-weighting of highly-rated securitizations of consumer and small business loans is higher than that of lower-rated corporates—surprising given the outperformance of consumer ABS over, for instance, CLOs during the crisis.
- Liquidity Coverage Ratio: The LCR rules do not treat any tranche of ABS as a high-quality liquid asset (‘HQLA’). The LCR has reduced investor interest in ABS and curtailed the supply of credit to consumers and small businesses.
- Fundamental Review of the Trading Book: Under this proposal, the risk-weighting given to many securitizations, including AAA paper, will soar – in some cases doubling, or more. When multiplied by the doubling of the Tier 1 capital required by Basel III, large banks could face a quadrupling of their cost of holding even AAA consumer ABS.
The consequences of current and proposed regulations are significant as banks currently hold around 15-20% of ABS at any given time. Indeed, banks are responding to incentives by shrinking balance sheets and shedding liquidity-providing or lending businesses that cannot clear ROE hurdles after capital charges.
We expect policy makers will re-examine the above rules while maintaining post-2008 regulations that reduce informational asymmetries and promote price discovery.
- Asset Review tests: Section 945 of Dodd-Frank requires the SEC to issue rules requiring an asset-backed issuer to perform a review of the assets underlying the ABS, and disclose the nature of such review.
- Disclosure: Section 942 contains disclosure and Exchange Act asset-level and loan-level reporting requirements for ABS issuers.
- Transparency: Post-trade transparency via TRACE covering Rule 144A and publicly registered securities.
Against this evolving regulatory landscape, platforms such as PeerIQ will play a role in enabling consumer and small business credit to successfully fund via the capital markets.
- IMN’s Investors’ Conference on Marketplace Lending, December 1st in New York. COO, Kevin Reed, will speak on a panel titled, “Third Party Loan Valuation.” Ram will speak on the panel, titled, “Assessing the Relative Value of Securitization as a Funding Tool”.
- Opal Group’s, “Marketplace Lending and Alternative Financing Summit” December 4-6 in Dana Point, CA. Ram will join a discussion on “Getting Prepared as a First Time Securitization Issuer”
PeerIQ in the News:
- U.S. Consumers Are Increasingly Defaulting on Loans Made Online (Bloomberg, 11/15/16)
- Donald Trump, the Securities & Exchange Commission, and FinTech (Medium, 11/15/16)
- Mary Jo White Leaving SEC Before Trump takes Office (CNN, 11/14/16) Mary Jo White announced plans to step down as chair of the SEC before President-elect Donald Trump takes office.
- Surge in Online Loan Defaults Sends Shockwaves Through the Industry (ZeroHedge, 11/16/16)
- Property Watch: Three Leases Signed at Kaufman Buildings (WSJ, 11/13/16)
- CFSI Study: Payday Shrinks While Underserved Consumers Pay More for Auto Insurance (CFSI, 11/17/16) Financially underserved consumers in the U.S. spent approximately $141 billion in fees and interest during 2015.
- Incoming CEO of Online Lender Prosper Aims to Reverse Drop in Loan Activity (WSJ, 11/18/16) Prosper CFO David Kimball is set to assume the role of CEO after settlement with Colchis.
- 2017 Will Be A Huge Year For Bank Partnerships (LendAcademy, 11/14/16) Consistent with PeerIQ’s hypothesis, Jason Jones expects bank partnerships to rapidly accelerate in 2017.
- Andreesen Horowitz Leads $15 million Investment in PeerStreet (Reuters, 11/17/16) PeerStreet, the leading marketplace for investing in real estate backed loans, announced a Series A funding round led by Andreessen Horowitz.
- Fired LendingClub CEO Sets Up Rival Lender Nearby (WSJ, 11/16/16) Renaud Laplanche has started a company called Credify Finance Corp.
- A Bank Disrupter Wants to Become…a Bank (WSJ, 11/16/16) Zopa seeks a banking license to marry its low-cost operations with stable deposits consistent with PeerIQ’s hypothesis of greater bank and FinTech partnerships.
- Four Lessons as Rating Firms Look at Marketplace Lenders (American Banker, 11/10/16) Ratings agencies for marketplace lenders would benefit from encouraging due diligence and research, and providing tools for doing so.
- Silicon Valley Investor Peter Thiel Will Join Trump’s Transition Team (Fortune, 11/11/16) Silicon Valley investor, Peter Thiel, is joining President-elect’s transition team.
- US Seizes $30 MM in Fake Dollars, Biggest Bust Ever (Reuters, 11/18/16) Efforts to address fake news and fake dollars continue.