Marketplace Lending

Supervisory Insights Winter 2015

arketplace lending is a small

but growing alternative to

traditional financial services

for consumers and small businesses.

Attracted by opportunities for earnings

growth, some banks have entered the

marketplace lending business either

as investors or through third-party

arrangements. As with any new and

emerging line of business, marketplace

lending can present risks. Finan-

cial institutions can manage these

risks through proper risk identifica-

tion, appropriate risk-management

practices, and effective oversight.

Conversely, failure to understand

and manage these risks may expose a

financial institution to financial loss,

regulatory action, and litigation, and

may even compromise an institu-

tion’s ability to service new or existing

customer relationships. Before partici-

pating in marketplace lending, finan-

cial institution management should

identify potential vulnerabilities and

implement an effective risk-manage-

ment strategy that protects the bank

from undue risk.

This article is intended to heighten

bankers’ and examiners’ understanding

of marketplace lending and potential

associated risks, including those aris-

ing in third-party arrangements. The

article also highlights the importance

of a pragmatic business strategy that

considers the degree of risk together

with the potential revenue stream, and

emphasizes the importance of banks

exercising the same due diligence they

practice whenever they extend credit

to a borrower.

Marketplace Lending Defined

For purposes of this article, market-

place lending is broadly defined to

include any practice of pairing borrow-

ers and lenders through the use of an

online platform without a traditional

bank intermediary. Although the

model, originally started as a “peer-to-

peer” concept for individuals to lend to

one another, the market has evolved

as more institutional investors have

become interested in funding the activ-

ity. As such, the term “peer-to-peer

lending” has become less descriptive of

the business model and current refer-

ences to the activity generally use the

term “marketplace lending.”

Marketplace lending typically involves

a prospective borrower submitting

a loan application online where it

is assessed, graded, and assigned an

interest rate using the marketplace

lending company’s proprietary credit

scoring tool. Credit grades are assigned

based on the marketplace lending

company’s unique scoring algorithm,

which often gives consideration to a

borrower’s credit score, debt-to-income

ratio, income, and other factors set

by the marketplace lender. Once the

application process is complete, the

loan request is advertised for retail

investors to review and pledge funds

based on their investment criteria.

A loan will fund from the monies

collected if investors pledge sufficient

capital before the deadline stated in

the loan request (e.g. 14 days after the

request is posted). As an alternative

to funding loans through such retail

investments, institutional investors can

provide funding through whole loan

purchases or direct securitizations.

When a borrower’s requested loan

amount is fully pledged, the market-

Marketplace Lending

Supervisory Insights Winter 2015

place lending company originates and

funds the loan through one of two

frameworks: 1) the company lends the

funds directly (subsequently referred

to as a “ direct marketplace lender”)

or 2) the company partners with a

traditional bank to facilitate the loan

transaction (subsequently referred

to as a “bank-affiliated marketplace

company”).

A direct marketplace lender typi-

cally is required to be registered and

licensed to lend in the respective

state(s) in which it conducts business.

Direct marketplace lenders facilitate

all elements of the transaction, includ-

ing collecting borrower applications,

assigning credit ratings, advertising the

loan request, pairing borrowers with

interested investors, originating the

loan, and servicing any collected loan

payments. As part of the transaction,

direct marketplace lenders issue inves-

tors either registered or unregistered

security notes (subsequently referred

to as “security notes”) in exchange

for the investments used to fund the

Direct Funding Model

BORROWER LENDERS/INVESTORS

Borrower applies for a loan

Loan disbursed to borrower

Loan repayment net service fee

Investor receives security note

Commits funds to a borrower

Direct

Marketplace

Lender

Monthly loan payments

Figure 1: Illustration of Direct Funding Model

Figure 2: Illustration of Bank Partnership Model

Bank Partnership Model

Borrower applies for a loan

Monthly loan payments

Loan is made to borrower

BORROWER

Refers loan request

Sells loan to marketplace

lending company

Loan repayment net service fee

Investor receives security note

Commits funds to a borrower

LENDERS/INVESTORS

Bank-affiliated

Marketplace

Company

Financial

Institution

Supervisory Insights Winter 2015

loan. Consequently, the borrower’s

repayment obligation remains with

the direct marketplace lender, the

security notes issued to investors

become the obligation of the direct

marketplace lender, and the investors

are unsecured creditors of the direct

marketplace lender. (See Figure 1 on

the previous page for an illustration of

this process.)

Some marketplace lending compa-

nies operate under the second

framework by working through a

cooperative arrangement with a

partner bank. In these cases, the

bank-affiliated marketplace company

collects borrower applications, assigns

the credit grade, and solicits investor

interest. However, from that point the

bank-affiliated marketplace company

refers the completed loan application

packages to the partner bank that

makes the loan to the borrower. The

partner bank typically holds the loan

on its books for 2-3 days before selling

it to the bank-affiliated marketplace

company. Once the bank-affiliated

marketplace company purchases the

loan from the partner bank, it issues

security notes up to the purchase

amount to its retail investors who

pledged to fund the loan. By the end

of the sequence of transactions, the

borrower’s repayment obligation

transfers to the bank-affiliated market-

place company, and the security

noteholder maintains an unsecured

creditor status to the bank-affiliated

marketplace company, which mirrors

the outcomes described under the

direct funding framework (see Figure

2 on the previous page). In certain

circumstances, some institutional

investors may invest in whole loan

transactions, which are often arranged

directly between the interested parties

and outside any cooperative arrange-

ment with a partner bank.

Once the process is complete,

borrowers begin making fixed monthly

payments to the bank-affiliated

marketplace company which issues a

pro rata payment to the investor, less

loan servicing fees.

Common barriers to entry for banks

and other traditional financial services

entities include state licensure laws,

capital requirements, access to financ-

ing, regulatory compliance, and secu-

rity concerns. Some of these barriers

may not exist for marketplace lending

companies. New start-up marketplace

lenders may be established quickly

and often with a unique niche to

capture a particular share of the

market. In 2009, industry analysts

with IBISWorld identified at least

three marketplace lending companies;

by 2014, the number had grown to 63

marketplace lending companies.

As of

September 2015, the number of estab-

lished marketplace lending compa-

nies totaled 163 with new entrants

continuing to join the competitive

market.

Concomitant with the increas-

ing number of market participants,

new or expanded product lines are

introduced as companies attempt

to establish a niche position in the

market. Some examples of market-

place loan products include unsecured

Marketplace Lending

continued from pg. 13

Omar Khedr, “Front money: Revenue will rise, but regulations threaten industry profitability,” IBISWorld Industry

Report OD4736 Peer-to-Peer Lending Platforms in the US, December 2014. (A subscription to IBISWorld is needed

to view this report.) http://clients1.ibisworld.com/reports/us/specializedreportsarchive/default.aspx?entid=4736.

Omar Khedr, “Street credit: New industry’s explosive growth may meet regulatory hurdles,” IBISWorld Indus-

try Report OD4736 Peer-to-Peer Lending Platforms in the US, September 2015. (A subscription to IBISWorld is

needed to view this report.) http://clients1.ibisworld.com/reports/us/industry/default.aspx?entid=4736.

Supervisory Insights Winter 2015

consumer loans, debt consolidation

loans, auto loans, purchase financing,

education financing, real estate lend-

ing, merchant cash advance, medical

patient financing, and small business

loans.

The Importance of Effective

Risk Identification

The marketplace lending business

model depends largely on the willing-

ness of investors to take on the credit

risk of an unsecured consumer, small

business owner, or other borrower.

Given the market’s infancy and that

it has primarily existed in an envi-

ronment of low and steady interest

rates, current credit loss reports or

loss-adjusted rates of return may not

provide an accurate picture of the

risks associated with each market-

place lending product.

Further, each marketplace lending

company’s risk level and composi-

tion varies depending on the business

model or credit offering, with poten-

tially significant variations across

credit products. Given the credit

model variations that exist, using a

nonspecific approach to risk identi-

fication could lead to an incomplete

risk analysis in the bank’s market-

place investments or critical gaps in

bank management’s planning and

oversight of third-party arrangements.

As such, banks should perform a thor-

ough pre-analysis and risk assessment

on each marketplace lending company

with which it transacts business,

whether acting as an institutional

investor or as a strategic partner.

A comprehensive list of risks associ-

ated with marketplace lending is not

possible without an understanding

of the arranged lending activity and

the products offered. Although not

a complete list, some risks include

third-party, credit, compliance,

liquidity, transaction, servicing, and

bankruptcy risks. Before engaging in

marketplace activity, banks should

complete appropriate due diligence

and ensure effective risk identification

practices are in place as part of the

risk assessment process.

Third-party risk can vary greatly

depending on each third-party

arrangement, elevating the importance

for banks to conduct effective due

diligence. Banks are encouraged to

review the FDIC’s Financial Institution

Letter 44-2008 titled Guidance for

Managing Third-Party Risk,

which

discusses the critical elements to an

effective third-party risk management

process: (1) risk assessment, (2) due

diligence in selecting a third party, (3)

contract structuring and review, and

(4) oversight.

Before engaging in any third-party

arrangement, a financial institution

should consider whether the proposed

activities are consistent with the insti-

tution’s overall business strategy and

risk tolerances. Bank management is

encouraged to develop a strong under-

standing of the marketplace lending

company’s business model, establish

contractual agreements that protect

the bank from risk, regularly moni-

tor the marketplace service provider,

and require the marketplace lending

company to take corrective action

See FIL-49-2015 “Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan

Participations”, November 6, 2015 at https://www.fdic.gov/news/news/financial/2015/fil15049.html.

See FIL-44-2008“Guidance for Managing Third-Party Risk,” June 6, 2008 at https://www.fdic.gov/news/news/

financial/2008/fil08044.html.

Supervisory Insights Winter 2015

when gaps or deficiencies occur. This

due diligence may result in banks

requiring policies and procedures from

the marketplace lending company

with respect to legal and regula-

tory compliance prior to the bank’s

investment or before any services are

offered.

Some considerations include, but

are not limited to, compliance with

applicable federal laws such as lending

laws, consumer protection require-

ments, anti-money laundering rules,

and fair credit responsibilities along

with adherence to any applicable

state laws, licensing, or required

registrations. As with any third-party

arrangement, banks should monitor

marketplace activities and expect

marketplace servicers to undergo

independent audits and take correc-

tive action on audit exceptions as

warranted. Failure to do so could

expose a bank to substantial financial

loss and an unacceptable level of risk.

For banks contemplating a funding

relationship with a marketplace lend-

ing company, management should

consider several issues that could

affect the bank’s risk profile. (See Due

Diligence sidebar.) Banks also should

consider validating the marketplace

lending company’s compliance with

any applicable state or federal laws.

Negotiated contracts should consider

provisions allowing the financial

institution the ability to control and

monitor third-party activities (e.g.,

underwriting guidelines, outside

audits) and discontinue relationships

if contractual obligations are not met.

Compliance risk is inherent in any

marketplace lending activity. Banks

are accountable for complying with

all relevant consumer protection

and fair lending laws and regulatory

requirements and cannot assign this

responsibility to a marketplace lend-

ing company. Although marketplace

lending companies are required to

comply with many of these require-

ments, well-run bank programs should

include appropriate due diligence and

ongoing monitoring to validate that

the marketplace lending company

demonstrates adherence to these

requirements. Relevant laws may

Marketplace Lending

continued from pg. 15

Due Diligence

 What duties does the bank rely on the marketplace

lending company to perform?

 What are the direct and indirect costs associated with

the program?

 Is the bank exposed to possible loss, and are there any

protections provided to the bank by the marketplace

lending company?

 What are the bank’s rights to deny credit or limit loan

sales to the marketplace lending company?

 How long will the bank hold the loan before sale?

 Who bears primary responsibility for consumer compli-

ance requirements, and how are efforts coordinated?

 Is all appropriate and required product-related infor-

mation effectively and accurately communicated to

consumers?

 What procedures are in place to prevent identity theft

and satisfy other customer identification requirements?

 What other risks is the bank exposed to through the

marketplace arrangement?

Supervisory Insights Winter 2015

include the Truth in Lending Act

(TILA) that, among other things,

requires the disclosure of standard-

ized loan terms and conditions at

point of sale and in advertisements,

and Section 5 of the Federal Trade

Commission Act,

which prohibits

unfair and deceptive acts or practices.

Consistent with the third-party risk

guidance,

banks also should evaluate

whether a bank-affiliated marketplace

lending company complies with fair

lending and other related laws includ-

ing the Equal Credit Opportunity

Act

(ECOA), which prohibits lend-

ers from taking action related to any

aspect of a credit transaction on the

basis of race, color, religion, and other

prohibited factors. Banks that partner

with marketplace lending compa-

nies should exercise due diligence to

ensure the marketplace loan under-

writing and pricing policies and proce-

dures are consistent with fair lending

requirements.

Transaction risk is present given

the potential for customer service

problems or a marketplace lending

company’s failure to fulfill its duties

as expected by the financial institu-

tion or its customers. Marketplace

loans may be subject to high levels

of transaction risk given the large

volume of loans, handling of docu-

ments, and movement of loan funds

between institutions or third-party

originators. Banks should anticipate

risks that could arise from problems

with customer service, product deliv-

ery, technology failures, inadequate

business continuity, and data security

breaches.

Servicing risk exists given the pass-

through nature of marketplace notes.

The investor becomes a creditor to

the marketplace lending company

and has no access to the borrower.

Therefore, if a marketplace lend-

ing company that services the loans

becomes insolvent, investors may

become exposed not only to bank-

ruptcy risk but also servicing risk if

the loan servicing process is disrupted.

In bankruptcy, a marketplace lending

company may be unable to fulfill its

note servicing obligations to inves-

tors even if the borrowers continue to

make timely payments.

Notwithstanding the fact that the

loans in which they invested are

fully performing, investors also may

be exposed to losses if other credi-

tors seek rights to these borrower

payments in the bankruptcy proceed-

ing. In the event a marketplace lend-

ing company becomes insolvent,

investors line up in bankruptcy court

to collect on monies owed on a pro

rata basis, with no investor having any

superior claim to a stream of payment

than any other, and often times with

interest halted once the bankruptcy

proceedings commence.

At a minimum, banks that invest in

marketplace loans should determine

whether back-up servicing agree-

ments are in place with an unaffiliated

company before investment. Banks, as

investors, committing significant capi-

tal to marketplace loans should assess

the marketplace lending company’s

creditworthiness with consideration

given to the business’s solvency prior

to investing the capital. Although this

See the Truth in Lending Act at https://www.fdic.gov/regulations/laws/rules/6500-3200.html#fdic65001026.1.

See Section 5 of the Federal Trade Commission Act at https://www.fdic.gov/regulations/laws/rules/8000-3000.

html.

Ibid.

See the Equal Credit Opportunity Act at https://www.fdic.gov/regulations/laws/rules/6500-200.html.

Supervisory Insights Winter 2015

condition may not afford complete

protection, it may mitigate some risk

of loss.

Liquidity risk is present given the

limited secondary market opportuni-

ties available for marketplace loans.

Although there are a few known

aftermarket providers, the secondary

market for marketplace loans gener-

ally is limited with resale opportunities

available only to a select few market-

place lending companies. Partner

banks with loans in their marketplace

pipeline may also experience liquid-

ity risk for those pipeline loans that

require funding.

Other considerations include compli-

ance with other state and federal

requirements, including anti-money

laundering laws. The partner bank

should evaluate the bank-affiliated

marketplace company as it would

any other customer or activity, and

financial institutions investing in

marketplace loans should exercise due

diligence in evaluating appropriate

compliance for any loan purchase.

A Supervisory Perspective

Before engaging in any marketplace

lending third-party arrangement or

balance sheet investment, a financial

institution should ensure the proposed

activities are consistent with the insti-

tution’s overall business strategy and

risk tolerances. FDIC examiners assess

how financial institutions manage

third-party relationships and other

investments with marketplace lenders

through review of bank management’s

record of and process for assessing,

measuring, monitoring, and controlling

the associated relationship and credit

risks. The depth of the examination

review depends on the scope of the

activity and the degree of risk associ-

ated with the activity and the relation-

ship. The FDIC considers the results of

the review in its overall evaluation of

management, including management’s

ability to effectively control risk.

FDIC examiners address findings

and recommendations relating to an

institution’s third-party marketplace

lender relationships and marketplace

loan investments in the Report of

Examination and within the ongo-

ing supervisory process. Appropriate

corrective actions, including formal

or informal enforcement actions, may

be pursued for deficiencies identified

that pose significant safety and sound-

ness concerns or result in violations

of applicable federal or state laws or

regulations.

Conclusion

Some banks are finding participa-

tion in the small but growing arena of

marketplace lending to be an attractive

source of revenue. With the market’s

infancy and its lack of performance

history through a complete economic

cycle, bank management should look

beyond the revenue stream and deter-

mine whether the related risks align

with the institution’s business strategy.

As noted earlier, financial institutions

can manage the risks through proper

risk identification, appropriate risk-

management practices, and effective

oversight. With the rapidly evolv-

ing landscape in marketplace lend-

ing, institutions should ascertain the

degree of risk involved, remembering

they cannot abrogate responsibility for

complying with applicable rules and

regulations.

Angela M. Herrboldt

Senior Examination Specialist

Division of Risk Management

Supervision

[email protected]

Marketplace Lending

continued from pg. 17