Rent-a-Bank payday loans have the highest loss rates in the banking system

Federal regulators have long expected banks to make loans with a high level of confidence that borrowers will repay them. But some banks controlled by the Federal Deposit Insurance Corp. (FDIC) regulators make loans on behalf of payday lenders that have dangerously high delinquency rates. These loans, known as “rent-a-bank” loans, have much higher loss rates than other products in the banking system, including small loans that banks offer directly to their own customers with low credit ratings.

These Rent-a-Bank loans are possible because banks only have to comply with the interest rate limits of their home state – and not those of the borrower’s state. For example, today half a dozen small banks lend on behalf of payday lenders at interest rates well above the borrowers’ home states, and the payday lenders can only lend under the banks’ bylaws. These loans are very similar to the types of indiscriminate loans offered to non-customers that banking regulators — due to their mandate to ensure the safety and soundness of the banking system by curbing dangerous practices — have stopped in the past.

Asset quality is a key metric under federal oversight used to assess a bank’s risk management, including an assessment of the likelihood that a bank’s loans will be serviced. The Bundesbank regulators specifically point out that small-dollar loans should be granted with “a high percentage of customers who successfully repay …”. Still, the top three payday loan companies involved in Rent-a-Bank lending had annual net losses averaging 50% in 2019, in contrast to other bank-issued lending, which has seen losses of between 2% and 9% exhibited. (The 2019 numbers are most relevant due to historically unusual borrowing and repayment patterns in 2020 and 2021 as a result of the government‘s response to COVID-19.) These loss ratios are similar to unbanked online payday loan rates based on the payday lenders business model from high customer acquisition costs, losses, overheads and interest rates and are about 12 times higher than credit card loss rates over the same period and more than five times higher than small loans from banks and credit unions – suggesting that the lending banks had a relatively low expectation of repayment.

Normally, the high loss rates on Rent-a-Bank loans would trigger regulatory scrutiny because they indicate uncertain lending. However, most of these loans or receivables are sold by the banks to their payday lending partners after origination, so the results of Rent-a-Bank loans remain largely hidden from bank auditors’ view. By selling the loans, the banks are essentially shifting data on the results from their books – which are checked in standard bank audits – and to the earnings results of payday lenders that are not.

There is a better way. Banks should provide access to secure credit by following the growing number of institutions offering small loans to their customers on fair terms while keeping losses in check. In fact, many banks serve borrowers with similar credit profiles as payday borrowers, but have much higher repayment rates; These banks are increasingly using technology – particularly through automating lending and origination – to outperform non-bank lenders in speed of lending, ease of access to credit and certainty of approval, which are key reasons borrowers are turning to borrowers have approached payday lenders in the past. This approach results in loans that are affordable for bank customers, improving both their financial well-being and their involvement in the banking system.

It’s time the FDIC put an end to the loss-making and expensive Rent-a-Bank lending that harms customers’ financial health and undermines safe lending practices in the banking system.

Alex Horowitz is an executive and Chase Hatchett is an executive associate of The Pew Charitable Trusts’ consumer finance project.