Fair Lending Risk Assessment

An earlier version of this article was published by Wipfli.

In the past few years, regulatory revisions, the formation of new entities, and new legislation have intensified the focus on fair lending examinations. Below are a few of the highlights: 

• In 2009, the Interagency Fair Lending Examination Procedures were revised to reflect changes in credit markets, credit products, and credit practices.
• In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, creating the Consumer Financial Protection Bureau. With the passing of Dodd-Frank, the newly formed CFPB became responsible for the oversight of Regulation B (Equal Credit Opportunity Act) and Regulation C (Home Mortgage Disclosure Act). Financial institutions’ prudential regulators (whether that’s the Federal Deposit Insurance Corp., the Board of Governors of the Federal Reserve System, the National Credit Union Administration, or the Office of the Comptroller of the Currency) remained responsible for assessing compliance with the Fair Housing Act and the Community Reinvestment Act for the institutions for to which they apply. (Credit unions are not directly subject to CRA.)
• In April 2012, CFPB issued a bulletin (2012-04) reaffirming the legal doctrine of disparate impact when assessing compliance with ECOA.
• In December 2012, CFPB and the Department of Justice signed a memorandum of understanding to strengthen coordination of fair lending enforcement. The agreement included a framework for sharing information, conducting joint investigations, and utilizing referrals between the two agencies.
• In February 2013, the U.S. Department of Housing and Urban Development released legislation confirming the use of disparate impact theory during Fair Housing Act examinations (FR Doc. 2013–03375).
• In August 2014, the CFPB released a proposed rule to implement amendments to HMDA reporting as outlined in Section 1094 of Dodd-Frank. The data the CFPB is proposing to add or modify include: information about applicants, borrowers, and the underwriting process, including age, credit score, debt-to-income ratio, and reasons for denial; information about the property securing the loan; information about the features of the loan, including additional pricing information, introductory rate period, and non-amortizing features; and certain unique identifiers, including the property address and loan originator identifier (FR Doc. 2014-18353).

The message is clear. If they haven’t experienced it already, financial institutions should expect fair lending examinations to be broader in scope, not only in terms of products (unsecured loans, indirect auto lending, credit cards, student loans, and small business loans, etc.), but also in terms of an enhanced focus on disparate impact. Disparate impact occurs when a seemingly neutral behavior or practice results in discrimination. Examinations will likely continue to focus on the more obvious fair lending violations, which include overt evidence and disparate treatment.  Overt evidence and disparate treatment involve discriminatory intent.  However, recent legislation also points to a more profound emphasis on disparate impact, which focuses on discriminatory consequences, regardless of intent. With more regulators involved, and intentions on coordinating efforts, credit unions should prepare for added fair lending scrutiny.

As always, the first step should be to complete a risk assessment. Fair lending is a concern, not just at origination, but through the entire life cycle Therefore, a fair lending risk assessment should consider available credit and marketing, underwriting, pricing, and servicing (including collections and loss mitigation).

Availability of Credit and Marketing

A review of a credit union’s branch locations and overall market area may identify neighborhoods that are underserved or excluded on a prohibited basis. This practice is commonly referred to as redlining.  In addition, a statistical analysis of a financial institution’s HMDA data may uncover disparities.

An evaluation of a financial institution’s marketing efforts as well as a review of customer complaints may identify ways in which certain geographies are marketed or treated differently.

Lastly, an assessment of the process used when guiding an applicant’s choice between loan products may also uncover fair lending issues. Commonly referred to as “steering,” fair lending concerns arise when a targeted group of applicants receives products with less advantageous terms (e.g., ARMs or subprime loans) on a prohibited basis.

Underwriting

With the implementation of the “qualified mortgage” and “ability to repay” rules in January 2014, underwriting has been in the news a lot lately. Many financial institutions' initial reaction has been to limit mortgage lending to qualified mortgages. However, financial institutions should proceed with caution, because this practice could have a disparate impact on a protected class.

Documentation and consistency are key components to justifying an underwriting decision. Documentation in loan files and nonoriginated files should be clear and comprehensive. Moreover, consistent processes lead to consistent treatment. Broad discretion with respect to granting underwriting exceptions should be prohibited.

As noted, the focus of fair lending examinations has been expanded to include non-mortgage products. Therefore, loan and underwriting personnel involved with unsecured loans, indirect auto lending, credit cards, student loans, and small business loans should be involved in the risk assessment process.

With regard to underwriting, the risk assessment process should include discussions on how income is calculated, the use of credit scores, collateral valuation, and policies on minimum loan amounts. A comparison of originated loans against denied loan requests for similarly situated applicants may also uncover fair lending concerns. This type of analysis can be done for all types of loan products.

Pricing

Deviations from a financial institution’s pricing policy are a potential fair lending red flag. Similar to underwriting, allowing broad discretion in loan pricing may lead to fair lending concerns. Therefore, whenever possible, financial institutions should have policies that limit or eliminate lender discretion in setting pricing and terms for loan products.

Recent fair lending enforcement actions by the Department of Justice illustrate the importance of a consistent application of pricing policies. For example, in June 2011, Nixon State Bank (Nixon, Texas), with assets of approximately $70 million, reached a settlement with the U.S. Department of Justice to resolve allegations that it charged higher prices on unsecured consumer loans made to Hispanic borrowers through the bank’s branch offices in violation of ECOA. Specific terms of the settlement included establishing uniform pricing policies, conducting employee training, and paying nearly $100,000 to resolve allegations that it engaged in a pattern or practice of discrimination on the basis of national origin.

Servicing, Collections, and Loss Mitigation

In January 2014, final rules of the Dodd-Frank Act amending mortgage servicing requirements went into effect. These rules are specific to mortgage loan servicing; however, many of the general concepts can be useful in assessing fair lending risk in servicing all loan products. Financial institutions should evaluate their procedures for assessing late fees, as well collection and loss mitigation practices.

Fair lending concerns have even expanded to other real estate owned properties. In June 2012, the Federal Reserve released guidance on the management of OREO properties. Specifically, financial institutions were asked to review their practices with regard to the marketing and maintenance of OREO properties to ensure they have not done so on a prohibited basis.

Conclusion

Regulatory and enforcement trends indicate an intensified focus on fair lending examinations going forward. Fair lending examinations will concentrate on the entire credit life cycle, from the marketing of loan products to loss mitigation and collection practices. In addition, recent regulatory guidance suggests a heightened emphasis on non-mortgage products as well as disparate impact.

Whether or not fair lending concerns uncovered during an examination result in an enforcement or legal action, the residual costs related to negative public opinion and employee morale may be even greater than penalties assessed in conjunction with an enforcement action. To understand their level of exposure, financial institutions should conduct a fair lending risk assessment to identify any areas where policies, procedures, or practices may result in discrimination against applicants or borrowers on a prohibited basis. Early identification and resolution of potential fair lending concerns will ensure financial institutions are ready for their next fair lending examination.

Craig Johnson, CRCM, CMQCS, is manager at Wipfli, LaCrosse, Wis.