The Consumer Finance Protection Bureau (CFPB) swept the industry earlier this month with a set of proposed rules that would prohibit mandatory arbitration clauses that deny groups of consumers their day in court.
According to the announcement, the CFPB wants to cut off lenders’ ability to include clauses prohibiting borrowers and bank account holders from filing or joining class action lawsuits in their contracts.
Moody's Investors Service released a report recently that the risks associated with the rule come twofold for lenders and securitizations if the CFPB adopts the arbitration rule:
- The fact that the proposed rule would not affect contracts outstanding before it is finalized would lessen its effects initially, as well as over the longer term for contracts on products that typically have long lives such as credit cards.
- If adopted, the rule would expand legal risks for banks and other financial companies, and could adversely affect some securitizations. Some of the negative effects, however, would be offset if the rule leads to improved borrower credit quality by ending practices that weaken consumers’ finances.
The Moody's report determined that the CFPB's proposed regulation does pose risks for financial services companies and securitizations, however, the impact will be limited in the early stages.
"The proposed regulation that the CFPB released last week to prohibit clauses in US financial contracts that prevent consumers from taking part in class-action lawsuits would create new risks for financial services companies and some securitizations tied to consumer loans," Moody's said. "However, because only contracts entered into after the rule's compliance date would be subject to the regulation, the rule—if adopted in its current form—would likely have no immediate material effect on potentially affected parties such as U.S. banks, finance companies, and securitizations."
Ultimately, the report showed that banks and finance companies face much higher litigation risk and potential reputation damage over time if the CFPB moves forward with the arbitration.
"Over time, the rule would expose banks and finance companies to an increasing risk of litigation and settlements with customers, as well as potential reputational damage. The impact would depend on the size and success rate of class-action lawsuits," the report said. "Nevertheless, the rule would also expand future legal risks for banks when bank profitability is constrained and their regulatory and litigation risks continue to be elevated."
Between 2008 and 2014, U.S.-based global investment banks set aside $139 billion in litigation provisions and are still enduring outstanding legal actions related to mortgages and other matters, the report showed.
"If financial companies negatively affected by lawsuits play key roles in securitizations, a weakening of their financial position could also weaken the credit quality of the transactions in certain cases, especially if the companies already have weak credit profiles," Moody's said.
On the upside, Moody's found that if consumers are given more legal recourse, there will be some offsetting positive effects on the credit quality of securitizations because borrowers' finances will be strengthened.
"Settlements or court rulings that require consumer-friendly adjustments to lender or servicer practices can be more important in this regard than the often small monetary awards that individual consumers win through class-action litigation," the report said.