How Banks Use Fear to Make You Pay More for a Loan

In this era of attention-getting sound bites, the financial services industry has come up with one that seems to work every time.

Beefed-up regulatory oversight and capital requirements? It’ll hurt consumers. Bolstered securities disclosure statements? It’ll hurt consumers.

The industry repeatedly uses the word “regulation” as code for tougher lending times ahead. Indeed, added regulation and enhanced oversight don’t come cheap. For example, lenders are having all sorts of organizational and operational conniptions in the scramble to comply with the Consumer Financial Protection Bureau’s focus on the fair availability and servicing of consumer credit. But isn’t it possible that certain industry tactics and processes deserve to be more carefully overseen—if not changed? And although costs may very well increase and access to credit become more restrictive as a byproduct of the extra scrutiny, there’s good reason to believe these reactions will be short-lived. Here’s why.

The term “capital requirement” has to do with the amount of equity (aka net worth) that a lending institution has in place as a hedge against the losses it expects to incur in the normal course. Since the economic collapse that left a recklessly overextended financial sector on death’s — or, more accurately, the government’s — doorstep, however, it’s become exceedingly clear that in this business in particular, more net worth is better than less. The problem is that companies and their shareholders give up more — in terms of ownership stake — to obtain additional equity than they would to arrange for more debt.

Moreover, a key measurement that investors apply to all their holdings — return on equity — will likely take a hit as a result. That’s because when the same or less net income that a company earns in any given period is divided by a bigger equity number (as a result of the added outside investment), the ROE ratio will tumble. Here too, though, isn’t it possible that companies with stronger balance sheets may become more appealing to investors who value enterprises that can withstand the cyclicality of the U.S. economy?

Then there’s the matter of enhanced disclosure — or transparency for those who prefer corporate-speak — with regard to the loans that the originating lenders subsequently peddle to the same or different investors. The rationale behind the call for greater forthcomingness is so they might actually have more complete information on what it is that they’re being asked to buy.

Industry insiders and their lobbyists claim that more information for prospective investors means less privacy for those to whom the loans were made in the first place. But does that have to be the case? Having been on both the sending and receiving sides of appropriately neutralized loan-performance data, I have to wonder whether the privacy issue isn’t yet another smokescreen. Perhaps the real concern is that more disclosure may inspire investors to demand higher rates of return for pools of loans they now come to view as having greater risk. Or worse: they may insist that certain deals be eliminated from the larger transactions altogether.

So when the financial services industry talks about consumers being harmed, what it’s really saying is that lenders plan to pass on to their customers the costs (and, perhaps a little extra) that are associated with conducting their business in a more stable and forthcoming manner. The question is: For how long?

As it is with just about everything else in our free-market economy, financing rates and fees are linked to supply and demand. Sure, the Federal Reserve sets short-term interest rates, but the private sector determines the markup. In the end, though, borrowers decide if and when to bite. And since lending institutions are in business to make loans, it’s reasonable to conclude that when enough potential borrowers balk because of cost or terms, their bankers will blink rather than lose the deals they need to keep the lights on.

We’re already seeing that, as lenders have begun to rationalize away the hardened pricing and structuring positions they’ve attempted to institute. So it’s only a matter of time before the new normal becomes business as usual.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.