Indirect Lending: Compliance Risk Considerations
From time to time, the NAFCU Compliance Team receives questions from our members regarding indirect lending arrangements. Such partnerships with third-parties present plenty of opportunity to credit unions, by helping to connect credit unions with potential borrowers (and thus potential members). However, there are also some compliance risk considerations that come into play as well. Let’s go back to basics and review indirect lending, particularly in the context of the non-member applicant.
The National Credit Union Administration (NCUA) issued Letter to Credit Unions 10-CU-15 in August 2010, which specifically discusses the need for credit unions to conduct appropriate due diligence in indirect lending arrangements. The letter starts by defining what “indirect lending” means to the NCUA, noting that “[t]he most typical form is an arrangement where a credit union contracts with a merchant to originate loans at the point of sale, such as an auto dealer.” Indeed, most of the questions NAFCU receives on indirect lending focus on relationships with auto dealers, but – as the NCUA letter notes – indirect lending can involve other third-parties as well, including fintech companies as technology advances. Regardless of the type of entity that partners with a credit union in an indirect lending relationship, the 2010 letter cautions that “no credit union should delegate loan approval authority to a third party. Every credit union has the responsibility to perform its own due diligence, establish effective controls and monitoring systems to mitigate the risks to the credit union’s earnings and net worth” (Emphasis added). Thus, according to NCUA, a credit union should still be the ultimate decisionmaker regarding whether the loan application will be approved.
Compliance risk can arise if an indirect lending partner does not fully understand the difference between credit unions and other financial institutions. Whereas banks may be able to accept loan applications from basically anyone, federal credit unions (FCUs) are only authorized to make loans to their members. Thus, an applicant who applies for a loan through an indirect lending partner must become a member of the FCU before the loan can actually be made. This is discussed in NCUA Legal Opinion Letter 94-0424. Possibly recognizing that it could be time-consuming for an applicant to wait to go through the member onboarding process – and that such a delay might discourage applicants from seeking a loan from a credit union – that same legal opinion letter announces that it is permissible for an applicant to simultaneously apply for membership with an FCU and apply to borrow a loan from the FCU. NCUA states: “We have no problem with simultaneous membership and loan application, as long as the borrower is actually a member when the loan is made” (Emphasis added). The letter goes on to state that making the loan before the applicant has become a member would be a violation of the Federal Credit Union Act.
From the indirect lender’s standpoint, this may seem fairly straightforward – if a non-member is interested in a loan from an FCU, then they should provide a membership application together with the loan application. Ideally, the indirect lending partner would understand the FCU’s field of membership and only encourage non-members to apply if they could realistically join the credit union.
However, the compliance issues become more challenging when there are multiple parties involved in the lending transaction, such as co-borrowers. NCUA Legal Opinion Letter 95-0616, issued in June 1995, discusses the issue of non-members’ involvement in loan applications. In the letter, NCUA states that “[n]onmembers can participate in loans as long as their involvement does not distort the direct lending relationship between the FCU and the member.” As the letter goes on to explain, this means that non-members can agree to be legally liable for repaying the loan – such as by being a co-signor or co-guarantor. However, the letter makes clear that a non-member cannot receive the proceeds of an FCU loan, which means that a non-member cannot serve as a co-applicant or co-borrower. Thus, if two individuals walk into a dealership and wish to obtain a joint auto loan to purchase a vehicle together, both applicants would need to become members of the FCU before the loan is made, or a potential violation of the FCU Act could result.
What about married couples? Do they both need to join the credit union? According to the June 1995 letter linked above, the answer is “it depends.” That letter considers a hypothetical married couple in which the husband is a member of an FCU, but his wife is not. In a situation in which the couple applies jointly for a loan to consolidate the husband’s debt, NCUA explained that such a joint application could be permissible because the spouse that is a member of the FCU – the husband – would receive the “full benefit” of the loan. Additionally, the wife would still be jointly and severally liable for the debt, and “treating the nonmember wife as a joint applicant would serve to provide additional assurance of marital estate assets being available as a source of repayment.” The NCUA then opined that if the loan were to consolidate the debts of the wife (i.e. the non-member), then a joint loan would be inappropriate – presumably because a non-member would receive the “full benefit” of the loan. Thus, it seems that whether a non-member spouse can be included as a co-borrower or co-applicant depends on which spouse will receive the “full benefit” of the loan, and whether addition of the non-member spouse is done mostly to contribute marital estate assets to the repayment of the loan and to make the spouse liable for the debt. While NCUA does not say it explicitly, the letter seems to imply that if the spouses would equally benefit from the proceeds of the loan, then they would both need to become members of the FCU before the loan is made.
As one can imagine, it may be difficult for a third-party to keep track of the nuances of the NCUA opinions discussed above. Nevertheless, compliance risk can result if an indirect lending partner were to send applications to a FCU that feature a non-member co-borrower or co-applicant, especially if that application were to fall through the cracks and be approved without first making the co-applicant or co-borrower a member of the FCU. In fact, the NCUA Examiner’s Guide discussed indirect lending and, in a section labelled “potential problems,” warns that “[t]he dealer’s involvement may increase the credit union’s potential for making a loan to a non-member or ineligible member, thus increasing reputation risk.” Thus, credit unions may want to have policies and procedures in place for reviewing the applications received from their indirect lending partners to ensure that all applicants are members of the FCU or are applying for membership. Finally, credit unions may want to have contracts with their indirect lending partners that require the indirect lender to comply with applicable laws and regulations, and to possible indemnify the credit union in the event that violations occur.
About the Author
Nick St. John, was named Director of Regulatory Compliance in August 2022. In this role, Nick helps credit unions with a variety of compliance issues.