On Tuesday, the Senate voted 52-47 - largely along party lines but with three Republican votes - to use the Congressional Review Act (CRA) to strike down an OCC rule intended to provide clarity into which entity is the “true lender” in fintech-bank lending partnerships. The “true lender” question was addressed by the OCC last October following the finalization of a separate rule by the agency earlier last year to codify the “valid-when-made” doctrine, which permits banks to transfer loans to other firms including fintechs even if state interest rate caps would prohibit the transferee from issuing the loan. However, the valid when made rule left open the question of which firm is deemed the “true lender” in lending partnerships, with some critics expressing concerns that nonbank lenders could use their bank partners as cover in order to avoid state requirements. The OCC issued its true lender rule to answer that question by stipulating that a bank is the true lender in loans issued by partnerships with fintechs if, on the date of origination, it (1) is listed as the lender in the loan agreement or (2) provides the funding for the loan. It also clarifies that in situations where one organization is listed as the lender and another provides the funding for the loan, the organization listed as the lender will be considered the true lender.
The original rule was welcomed by a number of banking and fintech industry groups but harshly criticized by Democrats, with 22 state attorneys general urging the agency to reconsider the rule, the attorneys general for New York, California and Illinois suing the agency, and Senate Banking Chair Sherrod Brown (D-OH) attacking the rule as enabling “rent-a-bank schemes in which payday lenders funnel their high-interest, predatory loans through national banks to evade state interest rate caps.” The House must still vote to overturn the rule, but it is expected to do so given its Democratic majority. If it is ultimately overturned, the OCC would be prohibited from issuing a “substantially similar” rule going forward.
The Senate vote came one day after Michael Hsu began his role as Acting Comptroller at the OCC. On his first day in office, he released a statement to OCC staff explaining that his top priority is “solving urgent problems and addressing pressing issues until the 32nd Comptroller is confirmed.” He outlined four key areas that he intends to address: 1) the disproportionate impact the pandemic has had on vulnerable communities; 2) risks and challenges associated with climate change; 3) technological change and digitalization; and 4) complacency around risk-taking.
The true lender rule’s days appear to be numbered, but as Democrats begin celebrating this legislative victory they may soon realize that much work remains to be done. Until a new rule is passed, determinations as to which entity is the “true lender” will likely be determined on a state-by-state basis with potentially uneven results, and the potential for litigation and regulatory uncertainty could have a chilling effect on fintech-bank lending partnerships as well as embedded lending products. Passing a new rule will be complicated because of the fact that the CRA’s prohibition on issuing “substantially similar” rules is an untested legal concept, and the OCC could find itself becoming the first test subject as courts determine how far a rule must diverge from one that has been reversed under the CRA.
Although addressing this issue could fall under Acting Comptroller Hsu’s focus on technology and innovation, he may choose to avoid controversial issues such as this one and turn his innovation agenda to address the backlog of digital and crypto firms’ charter applications. Regarding his other priorities, look for Hsu to take coordinated action with other regulators on climate change, with a potential first step being the development of a joint taxonomy. We also expect increased scrutiny from examiners on traditional safety and soundness areas such as loan portfolio management, credit concentrations, and risk governance. Specifically, focus will likely turn to credit risk management for portfolios that have experienced the greatest challenges through the pandemic, structural changes in the commercial real estate market, and retail credit risk management of consumers offered relief/forbearance, including fair treatment of such consumers.
Speeches and panel discussions at a series of industry events taking place over the course of this week provided a view into what the future of interest rate benchmarks will look like in a world after LIBOR, with discussion focusing on the role that forward-looking term and credit sensitive rates might play as part of the transition away from LIBOR. Over the past few days, regulators and key market participants alike have again stated their case for risk-free rates (RFRs) as the most prudent alternative to LIBOR across currencies and products.
At the International Swaps and Derivatives Association’s (ISDA) Annual General Meeting, the Financial Conduct Authority’s (FCA) Director of Markets and Wholesale Policy expressed confidence that RFRs, including SONIA and SOFR as alternatives to GBP LIBOR and USD LIBOR, respectively, would become “the center of gravity” for interest rate markets. During subsequent panel discussions, market participants generally agreed that liquidity would center around RFRs, while acknowledging that other alternatives might provide solutions in limited, specific portions of the market.
In his opening remarks at the Alternative Reference Rates Committee’s (ARRC) second SOFR Symposium, Bank of England Governor Andrew Bailey directly questioned whether “alternative credit sensitive benchmarks have truly addressed the weakness of LIBOR.” He noted that many of these alternatives continue to reference the same commercial paper and certificates of deposit markets that have exposed LIBOR to illiquidity and sudden rate dislocation at times of stress. Rather than relying on “small, and shrinking markets,” Bailey made the case for RFRs as the most sensible option as robust, primary replacement option.
In a subsequent speech, FRB NY President and CEO John Williams struck many of the same chords, calling for the embrace of SOFR as the cornerstone of a robust foundation of reference rates to underpin the financial system in the long-term. Just as Bailey did before him, he cautioned market participants against making choices that could “land us back in the same situation we’ve worked so hard to solve.”
Regulators and industry leaders are seemingly confident that RFRs will become the centerpiece of future markets. The remarks and commentary provided this week served as a concerted reminder of the fundamental issues that led to LIBOR’s demise in the first place, including dwindling volumes of real transactions on a daily basis used to derive a specific benchmark tenor and vulnerability to temporary illiquidity in underlying markets at certain points in the business cycle, resulting in market dislocation and sharp, amplified rate moves.
Unlike the regulators, market participants aren’t always able to look at the transition from LIBOR as an overarching, systemic problem. Rather, they are faced with the tactical challenges of operationalizing the necessary changes, such as implementing an overnight rate for a market that typically pays interest on a periodic basis. For a number of banks the change in reference rates will also affect how they manage the impact of their own funding costs through different economic environments. It appears clear that, at the very least in the US market, forward looking term versions of the RFRs and some of the credit sensitive rates will play a supporting role. As can be expected, market participants will continue to have different views exactly which and to what extent alternative reference rates will be broadly adopted. Rather than waiting for a consensus, which will require time to emerge, firms will need to evaluate the suitability of specific alternatives — and be prepared to explain the rationale behind their choices to their supervisors and, perhaps more importantly, to their customers.
Subscribe to PwC’s LIBOR Transition Market Update here to read more about these and other developments.