Regulation is a double-edged sword. It can restrict innovation in one sector, and spur innovation in another. Likewise, it can reduce risk in one industry and increase risk in another. Regulations imposed without the input and cooperation of the companies affected most by the new rules are likely to cause more harm than good. This why regulations are fiercely debated, especially in the financial services industry, a sector that has been forever changed by post-crisis rules.
A good example of this dynamic is how regulatory reforms have led to a shift away from banks. Nonbank lending has existed for decades, but the burgeoning alternative lending space came into prominence in large part thanks to two sweeping pieces of financial regulation: the Dodd-Frank Act and Basel III capital reforms.
These regulations, including new underwriting requirements and higher mandatory levels of capital held in reserve, reduced how much risk banks could take on, resulting in many traditional banks taking a step back from lending to all but the largest and most creditworthy borrowers.
Nonbank lenders stepped up to fill the void and are now a crucial source of capital for small- and medium-sized businesses and other borrowers who collectively fuel the American economy. In 2017, there was an estimated $380.6 billion in total alternative lending volume to small-to-medium enterprises (SMEs) and individual borrowers, up from $263.9 billion in 2016. These numbers are continuing to rise, with volumes expected to nearly double to $750 billion by 2020.
Understandably, regulators are taking notice. As nonbank lenders further enter the mainstream financial community, regulation will inevitably increase.
There are two basic types of oversight: the voluntary kind where firms self-regulate, and the rules handed down by the SEC, Treasury Department and federal financial regulators. It doesn’t take a business degree to guess which of the two options the industry would prefer.
Although financial regulators have given nonbank lenders freedom to innovate within certain parameters, the industry has stood up in many ways to self-regulate. For example, the nonbank lending industry formed the Innovative Lending Platform Association (ILPA), a trade organization of online lenders dedicated to advancing best practices and standards that support responsible innovation and access to capital for small businesses.
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The nonbank lenders that take steps now to prepare and adopt best practices will be best-positioned to succeed as regulation evolves. Here are the top three things I’d like to see in a regulated environment for nonbank lenders:
- A specialist regulatory agency, or self-regulatory organization, dedicated to nonbank lenders: This would follow the model of other specialist agencies that exist for niche financial sectors, such as life insurance companies and credit unions. It would ensure that there is a consistent regulatory framework, and that nonbank lenders don’t get unfairly pigeonholed into complying with regulations that may not be appropriate for their business models.
- Less stringent liquidity requirements than what is required for traditional banks: We all saw what happened to the lending sector after Dodd-Frank and Basel III imposed strict capital reserve requirements on the largest banks, particularly those that are defined as being systemically important. While the strictest regulations only apply to the largest banks, the federal regulatory agencies still have broad authority to expand these requirements to other financial institutions. But nonbank lenders are small in comparison to the big banks, and not as exposed to global market activities, and thus should be free to take on more risk within reason so they can serve more businesses.
- More transparency into what’s on a lender’s balance sheet: If there’s one lesson we’ve learned from the financial crisis, it’s that a bank or a lender’s financial health may not be what it seems. While it’s impossible to predict future market conditions, it’s important for borrowers, creditors and investors to have transparency into any potential business risks. That transparency starts by understanding exactly what is on a company’s balance sheet and how that business calculates risk. This is particularly true for the nonbank lending space, which features a spectrum of different business models ranging from direct lending, where all the loans are backed by collateral on the lenders’ balance sheet, to marketplace lending, where loans are funded via a combination of institutional and retail investors
- It’s up to all of us in the nonbank lending space to take the initiative and contribute ideas that we can come together and debate. The alternative — waiting for state and federal authorities to come up with regulations — may disrupt the sector and the flow of capital, and potentially put many nonbank lenders out of business.
I know which option sounds better to me.
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