Case to Watch: Regulating interest rates in a digital world

Four thousand U.S. dollars are counted out by a banker counting currency at a bank in Westminster
REUTERS/Rick Wilking
  • States challenge FDIC and OCC rules on bank loan interest rates
  • Say rules overstep authority, allow predatory schemes
  • Banking industry says rules critical to debt market

(Reuters) - With interest rates expected to rise, banking lawyers are closely watching two cases in California over rules they say are needed to create certainty in lending, but which some states and consumer groups say invite abuse.

California and several other states want U.S. District Judge Jeffrey White in Oakland to block federal rules they claim allow consumer finance companies to use banks as a cover to lend at illegally high rates.

The states have filed suit against the Federal Deposit Insurance Corporation, along with a parallel case against the Treasury Department's Office of the Comptroller of the Currency.

The lawsuits challenge the FDIC's and OCC's "valid when made" rules, which state that when a bank lends at a valid interest rate, the rate remains valid when the loan is sold to a nonbank.

White is poised to rule on summary judgment motions in both cases.

Maria Earley, a Morrison & Foerster partner who represents financial companies, said the industry views the rule as essential to banks' ability to sell and securitize loans.

"You have to have secondary markets to keep credit flowing. Taking down 'valid when made' would severely disrupt that," she said.

If the regulators lose, the case is likely to be appealed "all the way up," Earley said.

The rules build on federal banking law, which allows banks to charge the interest rates allowed by their home states, regardless of where the borrower lives.

California and the other states, which include New York and Illinois, argue the federal agencies overstepped their authority by letting banks essentially transfer that privilege to non-bank financial companies in an end-run around state regulation of consumer finance.

The dispute stems from the 2nd U.S. Circuit Court of Appeals' 2015 decision in Madden v. Midland Funding LLC. The court held that Midland, one of the largest debt collectors in the U.S., was subject to New York's 25% interest rate cap and could not charge 27% on a credit card debt it had bought from a national bank.

The ruling rattled the financial industry, which lobbied regulators for a fix.

The agencies argue in both cases before White that the resulting "valid when made" rules are a reasonable way to fill the gaps in federal banking law that Madden exposed.

The federal law does not specify at what point interest should be considered valid under the law of a bank's home state, or what happens to interest rates when bank loans are sold.

The rules address those points in a way that creates stability in the credit markets and would not upend the terms of existing debt contracts when they are transferred, the OCC and FDIC said in their briefs.

Several banking industry groups have filed briefs in support of the regulators, arguing that rejecting the rules would jeopardize secondary debt markets that allow billions of dollars to flow from lenders to U.S. borrowers every year.

Consumer groups including the Center For Responsible Lending have also weighed in, arguing the credit market functioned without the rules. They point instead to their potential to encourage "rent a bank" arrangements, where nonbank lenders market loans nationally and banks in states with no rate caps act as originators for a fee.

Georgetown Law professor Adam Levitin, who filed a brief supporting the states, said only a handful of companies are using that model now. But if the rules stand, he expects that to change.

"There will be a giant hole carved in state usury laws and a huge amount of business will be funnelled through it," he said.

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Jody Godoy reports on banking and securities law. Reach her at