The removal of the 5% cap on eligible obligations also has the potential to be a game-changer.
In December, the National Credit Union Administration board issued a proposed rule entitled Financial Innovation: Loan Participations, Eligible Obligations, and Notes of Liquidating Credit Unions that should, once finalized, make it easier for credit unions to partner with financial technology companies in indirect lending relationships.
The proposed rule does not necessarily break new ground because many credit unions already engage in indirect lending with fintech companies, however, the updated regulation would codify longstanding NCUA guidance; eliminate the existing regulatory cap on credit unions’ purchases of “eligible obligations,” i.e. a loan made by an unrelated lender that the credit union later acquires; and clarify when the credit union is considered the “originating lender” in an indirect lending relationship.
NCUA last updated these regulations 10 years ago when app-based financial services were less advanced. The agency is expected to issue a final rule on financial innovation before the end of this year.
App-Based Financial Services in Action
Recently, many credit unions, including many of my clients, have partnered with fintech companies like Upgrade and Upstart to reach borrowers who may not have previously considered seeking a loan from a credit union. These fintech companies typically use mobile app-based platforms to connect individuals with credit unions they are eligible to join. The credit union then makes a loan—such as an auto loan or a signature loan—to the member through the app using the credit union’s own underwriting standards that the fintech has agreed to follow.
The loan and its related documents are usually assigned to the credit union either right away or within a few days and in most cases, the credit union can force the fintech to buy back any loans that did not adhere to the credit union’s underwriting standards. These fintech partnerships have helped credit unions reach new, younger members who are in the borrowing phase of their lives, which reduces the problem of “graying” credit union memberships dominated by older net savers who are less likely to need loans.
Classification of Fintech Loans Tricky
Confusion erupted, however, over how credit unions should classify fintech loans for compliance purposes. Where these indirect loans that were eligible to be sold to other credit unions as loan participations? Or were they “eligible obligations” of members?
This regulatory classification issue is significant for two reasons. First, credit unions would easily get “capped out” buying loans classified as eligible obligations under current NCUA rules because they limit credit unions’ holdings of eligible obligations to no more than 5% of the credit union’s paid-in-capital and surplus (i.e. shares plus post-closing, undivided earnings).
The NCUA rule on eligible obligations, however, contains an exemption when a “federal credit union makes the final underwriting decision and the sales or lease contract is assigned to the federal credit union very soon after it is signed by the member and the dealer or leasing company.” This provision can also apply to state-chartered credit unions pursuant to state credit union act “wildcard” parity statutes.
NCUA’s Office of General Counsel has also interpreted the term “final underwriting decision” in legal opinions to include third-party computerized underwriting systems following the credit union’s pre-approved underwriting rules because then the credit union has made an “advance decision” on the loan application.
Second, another NCUA legal opinion letter interpreted the agency’s loan participation regulation, which only allows credit unions to purchase a loan participation interest from the “originating lender,” so that credit unions were legally considered the “originating lender” if they made indirect loans that met the exemption in the eligible obligation regulation.
Most credit unions’ contracts with fintech companies I have reviewed should meet this existing exemption so that their loans made with fintech partners qualify as indirect loans where the credit union is the “originating lender.” Many of the NCUA guidance documents that support this determination, however, are relatively obscure, so credit unions’ classifications of fintech loans became a common examination topic.
In addition, some examiners questioned whether earlier NCUA guidance on indirect lending applied to credit union partnerships with fintechs given the technological and operational differences between app-based indirect lending and the more traditional indirect lending programs located at physical retailers such as auto dealerships.
New Innovation Reg Should Clarify Matters
NCUA’s proposed Financial Innovation regulation seeks to eliminate this confusion. Specifically, the agency is proposing to move the indirect lending exemption in the eligible obligations rule to the more generally applicable rule on “Loans to members and lines of credit to members” as well as codify the agency’s legal opinions and remove the regulatory 5% cap on eligible obligations.
While removing the 5% cap on eligible obligations is the primary substantive change in the proposal, the updated rule’s clarifications should help limit compliance burdens on credit unions engaged in fintech indirect lending by reducing regulatory uncertainty. The removal of the 5% cap on eligible obligations also has the potential to be a game-changer because the issue of whether a loan is an indirect loan versus an eligible obligation will become much less important.
Most public comments supported finalizing the rule without significant modifications. The NCUA Board will likely issue the final version of this regulation in the second half of this year, and it seems unlikely that the board will make significant changes based on the comments. When the final rule does come out, expect for many credit unions that sat on the sidelines regarding fintech lending because they were unsure of the rules to take advantage of fintech partnerships to attract new members and increase loan demand.
Michael S. Edwards is an attorney-at-law with extensive experience representing credit unions, community banks and credit union organizations in the United States and around the world on a wide range of regulatory, compliance and other legal matters. Now with his own law firm based in the Washington, D.C., area, Edwards previously served as SVP/advocacy and general counsel of the World Council of Credit Unions and was senior assistant general counsel in the regulatory advocacy section of the Credit Union National Association.