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September 15, 2016

You borrowed money from a friend some time ago, and now you must pay it back. Unfortunately, its the end of the month and youre low on funds. What do you do? The average American looking for instant funding will approach a flashing stall right across the street saying fast cash, checks cashed, and so on. These funding stalls, commonly known as payday lenders, outnumber even the likes of Starbucks with respect to the number of outlets in the US. Payday loans areshort term loans with balloon payments. In most cases, the borrowers Social Security Number, bank statements, and pay slips are all that is needed to process the loan, as credit reports are generally not assessed while disbursing such loans.

So, in a nutshell, payday loans offer you the option to make an impulse purchase, take care of an unanticipated payment, flush in the operating capital for your small business, and so on – all without having to go through the typical process of availing a loan from a traditional bank. However, here are a few thingsyou must know before you opt for such loans. Due to the high risk involved, payday lenders charge exorbitant interest rates, and the balloon payments that borrowers end up paying can consume one-third or more of their subsequent paychecks.

A point worth noting is that payday lenders are a source of temporary relief to borrowers; in the longer run, these have a negative impact because they can render potential borrowers incapable of qualifying for mortgage loans. This is because underwriters see this as a reason for possible default, given the frequent loan repayment transactions that appear in the bank statements of payday borrowers. This information may also feature in the specialty credit reports that lenders have access to. According to research conducted by the Consumer Financial Protection Bureau (CFPB), the average payday borrower in the US is in debt for nearly 200 days more than half a year! As per a study by the Insight Center for Community Economic Development, payday lending resulted in losses to the tune of $774 million for the US economy in 2013.

The rapid emergence of payday lending can be attributed to the quick and high returns it offers to investors. In addition, since payday lenders are relatively insulated from regulatory oversight, it has been a lot easier for them to grab a notable share of the loan market. A probable adverse outcome of this growing trend could be that customers can get habituated to payday borrowing and display irrational spending behavior, which can in turn lead them into debt traps. This further makes it difficult to cover other loan commitments and expenses such as house mortgages, car loans, and so on. This has become a cause for concern for the CFPB and other regulators, and hence the need for stringent regulations for lenders of payday loans.

Now, both online lending platforms (such as LendUP, Avant, and Cash Advance) and in-store lenders are being brought under increased regulatory scrutiny. On June 2, 2016, the CFPB proposed the creation of a federal regulatory framework for payday lending, non-adherence to which can not only lead to penalties, but also result in revocation of licenses of lenders.

Regulators plan to limit the durations of $500 loans to a maximum of 90 days, with a further restriction on consecutive loans, introducing a cap on fees and related charges. Data reporting and disclosure requirements are also expected to become more stringent. CFPBs proposed governance framework will mandate lenders to assess borrowers creditworthiness.

The heightened regulatory oversight spells a host of changes for payday lenders. To prepare for impending regulatory examinations, payday lenders will need to revamp their operating process models and landscapes by establishing rules for the various product variants (short-term ATR, short-term alternative, longer-term ATR, longer-term alternative, and so on) in accordance with CFPBs guidelines.

The increase in the volume of payday loans disbursed, and the complexity in managing the different components of loan origination will require payday lenders to invest in the development or enhancement of their IT applications and processes. For instance, they will need to deploy advanced databases that can interface with a variety of conventional and unconventional data sources and fetch the required information to assess borrowers creditworthiness. Moreover, advanced analytics and reporting capabilities will be needed for audit purposes.

We believe that payday lenders should consider deploying sophisticated scoring engines for grading customers, robust mechanisms for interest rate control, strong customer due diligence processes, and a comprehensive framework for effective disclosure management and credit bureau integration for borrower assessment. They must also maintain internal reports to track borrowing restrictions laid out by the CFPB. An agile, extendible loan origination platform that allows faster processing of credit requests with the available data, and issues timely alerts and escalations in case of anomalies, is the need of the hour. This will provide lenders a comprehensive view of customers, thus facilitating effective risk management.

Balakrishna Rao is a Functional Consultant with the Lending practice of the Banking and Financial Services (BFS) unit at Tata Consultancy Services (TCS). He has been with TCS for over six years and is a Certified Associate in Indian Institute of Banking (CAIIB) from the Indian Institute of Banking and Finance, New Delhi, India. Bala holds a Post Graduate Diploma in Management from the Alliance Business School, Bangalore, and a Bachelors degree in Electronics and Computer Science from the National College, Bangalore, India. In his current role, he anchors strategic consulting and business analysis assignments for TCS banking clients, in the areas of consumer and commercial lending in retail and commercial loans as well as business trade services.


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