Banks are damned if they do, and damned if they don’t.
The sentiment today is that banks are too risk averse in lending, excluding the people most in need of financing. For instance, it’s harder today for an entrepreneur to get a bank loan to open a new small business.
But less than a decade ago, consumers raised hell because the banks, in a capitalist grab-all, lent money to borrowers, predominantly for mortgages, they had reason to believe would never be paid off.
As the recession cools, consumers, industry pundits and tech entrepreneurs are again grumbling about the socioeconomic bias in bank strategies.
Anti-bank sentiment is constant and cyclical, according to Vivek Jha, the commercial card payment lead at Carlisle and Gallagher, a business and technology consultancy.
Jha’s view is that the mainstream too often disregards the effect of government meddling with the free market through regulatory burdens, a factor he believes was key to the 2008 financial crisis.
He’s surrounded by this ideology since Carlisle and Gallagher works with seven of the top 10 financial institutions in North America, and nearly all the big banks base their operations in Wilmington, Delaware, not far from where he lives with his family. A well-known tax haven, Delaware revised its corporate laws to attract more businesses in the 20th century. And the strategy worked. Businesses of all kinds incorporate in the state hoping to minimize taxes, deal with friendlier courts and skirt strenuous regulation in other states.
While the state offers large corporates a beneficial regulatory structure, allowing companies to make and keep more money, Wilmington–and actually the whole state of Delaware–doesn’t offer affordable accommodations for travelers. When I searched Delaware in the Hostelworld app, it auto-corrected to New Dehli, India. And the cheapest hotels on Kayak were nearly $200.
This is mostly likely due to the low number of people that vacation in Delaware. While tourism contributed $2.2 billion to Delaware’s economy in 2012, the state has the reputation of being, well, dull (No thanks to Wayne’s World). Most people that visit the state are there for business, similar to Connecticut, using company cards to stay in Marriotts or Hiltons.
Banks set up shop in Delaware since its laws don’t specify a maximum interest rate that can be charged on credit cards. The federal government also has not set a limit on credit card interest rates. Today, the median penalty interest rate charged by banks is more than 29%.
Many might wonder why interest rates weren’t capped, but the federal government has to be careful with regulation as there are many times unintended consequences to legislation.
Back to lending…
In the 1990s, the federal government strengthened its stance on the Community Reinvestment Act, a 1977 law geared towards reducing discriminatory lending against low-income neighborhoods. The federal government wanted to make sure credit was issued to those most in need.
According to Howard Husock of the Manhattan Institute, a conservative American think-tank, after the crisis a mid-size bank CEO reported 20% of its Community Reinvestment Act-based mortgages were delinquent in their first year.
Several economists and industry experts, including Jha, contend efforts to extend the Community Reinvestment Act led to the easing of lending standards in the banking industry, inducing the crisis.
I tend to be a bit skeptical of this argument, since it sounds more like an excuse to shift responsibility. But it’s a valid point; the federal government stepped away from its homeownership push and banks then tightened their lending standards.
“Since the collapse of the financial market, banks are increasing their scrutiny of the credit-worthiness of their potential borrowers,” Jha says. “[Borrowers] must have higher credit scores and better payment histories to qualify for a loan.”
Which is why you won’t see the big banks setting up booths on university campuses–a customary practice nearly a decade ago–giving college students free shirts for filling out credit card applications.
But this retreat comes with it’s own set of problems for the underbanked and less affluent. Today, individuals and small businesses have trouble getting access to capital, which continues to pool at the top of the socio-economic ladder.
This is one of the reasons crowdfunding, whether it be rewards or equity-based, has taken off. According to David Frankel, chief marketing officer at New York-based Capify, alternative small business financing platforms like his firm can meet the lending needs banks can’t.
Capify specializes in funding service-oriented businesses such as bars and restaurants. The company, which receives money to loan from banks and institutional investors, offers two products to small businesses: a basic bank loan and a merchant cash advance.
Many small businesses have trouble getting loans from traditional financial institutions, Frankel says, whether it’s due to the borrower’s less-than-perfect credit, because the business doesn’t fit the mold, or because of regulation and risk.
So if these alternative lending providers do basically the same thing as banks, why can they do things the banks cannot? Because the industry is virtually unregulated.
In my mind, the regulation will come, and it might make the alt-lenders look pretty similar to the traditional ones.
Although Frankel says one of the competitive advantages of alt-lenders is that they allow the borrowers more flexibility with repayment. For instance, borrowers pay back the merchant cash advance product as a percentage of their receipts for the month, which provides relief for small businesses that deal with seasonality or natural ebbs and flows, he says.
For that flexibility, there’s a higher interest rate.
Currently regulators are trying to figure out just how to develop rules that protect consumers without stifling innovation. Many regulators, I assume, fear that if the alt-lending industry continues to stay unregulated, the space will eventually cave in like the markets in the summer of 2008.
“Will some [alt-lenders] get in trouble? Yes,” says Frankel. “Competitive pressures may make some of them do something imprudent … especially in the U.S.”
But ultimately, the alt-lending space is a beneficial means to moving capital out of wealth pools. While equity crowdfunding money generally comes from the financially elite, it still has the undertones of a more collaborative system, where smaller amounts are contributed by more people, distributing the risk.
But who loses out as alt-lenders disrupt the banking space? Community banks, Frankel says.
This could hurt less affluent consumers and the underbanked that rely on community banks, credit unions and payday lenders for credit, Jha says.
Plus community banks and local financial institutions have an incentive to invest more in the community since that’s its only market.
But the large, global banks are also trying to invest more into the communities that they do business in.
Jha has seen bank TV commercials beginning to reflect this shift. A consumer walks into a bank branch to chat with the teller about mortgages and notices a picture of the teller’s child in a baseball uniform, the same uniform the consumer’s son wears. The guys start talking about Little League, the banker casually tells the guy to refinance and the encounter leaves both of guys happy as larks.
This time, consumer sentiment is changing the business practices of banks without regulatory action. This doesn’t work in every scenario, mostly because consumer beliefs are hard to focus until something dramatic, like the financial crisis, happens. But it’s a step in the right direction that consumers are educating themselves and initiating change, before the government must demand it.