One subject always at the forefront of a regulatory compliance exam for any institution is Fair Lending. On the surface, the uninformed might say “Oh, that is not a problem for us, we’ll make a loan to someone from Mars if they apply and qualify”; however, fair lending is much more encompassing. The purpose of this article is to discuss some of the potential fair lending pitfalls that demonstrate the complexity of the subject of Fair Lending.
It is common knowledge that the area of Fair Lending basically entails the subject matter of Equal Credit Opportunity Act (ECOA) and Fair Housing Act (FHA). However, often overlooked is that ECOA covers Fair Lending in relation to small businesses, corporations, partnerships, as well as trusts.
Overt discrimination is “blatant” in turns of a written policy or an oral statement. A typical example is a financial institution combining the debts and incomes of married joint applicants to calculate the DTI; however, if unmarried calculating a separate DTI for each applicant.
Disparate treatment refers to a difference in treatment of underwriting, pricing, or approval toward a prohibited basis group. For example, a financial institution approves loans to non-minorities with bankruptcies, collections, etc. but denies loans to minorities with bankruptcies and collections. For mitigation of disparate treatment, the solution is to fully document all denial reasons (up to four), to document that exceptions to underwriting or pricing criteria are for a defensible business purpose (as examples – applicant has been a long time loan customer of our financial institution with an excellent payment history, applicant carries large deposit balances of our financial institution, etc.), and to maintain an institution exception review and approval process. “To meet competition” is NOT a defensible business purpose for Fair Lending. Checks and balances should ensure functionality. Also a documented secondary review process for HMDA applicable loans is a necessity (with such process occurring before communication of the credit decision to the customer).
Disparate impact refers to a seemingly neutral policy, that when applied, has a negative impact on a prohibited basis group. A typical example is a financial institution that sets a minimum amount for a closed end residential loan at $40,000. Such a policy could, in effect, cut off lending for an entire neighborhood. However, by providing documented substantiation that only a residential loan in excess of this amount is profitable, the financial institution has provided business justification for this policy and that there are no less discriminatory alternatives to achieve the business objectives of loan profitability.
Another Fair Lending related risk is steering (choice) relative to lending alternatives by an institution. If multiple lending options are available by an institution, applicants should be advised of the options. Advantages and disadvantages of each
should be explained. Standards for referring applicants to subsidiaries, affiliates, or other lending channels should be established. There should be review and monitoring and loan distribution by lending channel or product on a prohibited basis.
Redlining is another factor to consider. Monitoring of lending levels in minority tracts is important as less or non-existent lending levels in these tracts when compared to lending in non-minority tracts (considering demographic information and peer lending) can be indicative of redlining risk.
All these factors and more tie to the need for a comprehensive Fair Lending Risk Assessment. Such an assessment allows an institution to develop an effective fair lending compliance management program to mitigate Fair Lending Risk.
Failure to be proactive in terms of Fair Lending potential pitfalls can result in adverse legal and reputation risk. Fair lending is now a disclosed component of the CRA Public Performance Evaluation. Civil money penalties, restitution, and potential DOJ involvement can occur. Mergers, acquisitions, and financial openings can be affected.
Beware of the potential Fair Lending pitfalls, and work to mitigate them.