Are Bank Directors Worried Enough About Fair Lending?

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Bank directors and executives, be warned: Federal regulators are focusing their lasers on fair lending. 

If your bank has not modernized its fairness practices, the old ways of doing fair lending compliance may no longer keep you safe. Here are three factors that make this moment in time uniquely risky for lenders when it comes to fairness.

1. The Regulatory Spotlight is Shining on Fair Lending.
Fair lending adherence tops the agendas for federal regulators. The Department of Justice is in the midst of a litigation surge to combat redlining. Meanwhile, the Consumer Financial Protection Bureau has published extensively on unfair lending practices, including a revision of its exam procedures to intensify reviews of discriminatory practices.

Collections is one area of fair lending risk that warrants more attention from banks. Given the current economic uncertainty, collections activities at your institution could increase; expect the CFPB and other regulators to closely examine the fairness of your collections programs. The CFPB issued an advisory opinion in May reminding lenders that “the Equal Credit Opportunity Act continues to protect borrowers after they have applied for and received credit,” which includes collections. The CFPB’s new exam procedures also call out the risk of “collection practices that lead to differential treatment or disproportionately adverse impacts on a discriminatory basis.”

2. Rising Interest Rates Have Increased Fair Lending Risks.
After years of interest rate stability, the Federal Reserve Board has issued several rate increases over the last three months to tamp down inflation, with more likely to come.

Why should banks worry about this? Interest rates are negatively correlated with fair lending risks. FairPlay recently did an analysis of the Home Mortgage Disclosure Act database, which contains loan level data for every loan application in a given year going back to 1990. The database is massive: In 2021, HMDA logged over 23 million loan applications.

Our analysis found that fairness decreases markedly when interest rates rise. The charts below show Adverse Impact Ratios (AIRs) in different interest rate environments.

Under the AIR methodology, the loan approval rate of a specific protected status group is compared to that of a control group, typically white applicants. Any ratio below 0.80 is a cause for concern for banks. The charts above show that Black Americans have around an .80 AIR in a 3% interest rate environment, which plummets as interest rates increase. The downward slope of fairness for rising interest rates also holds true for American Indian or Alaska Natives. Bottom line: Interest rate increases can threaten fairness.

What does this result mean for your bank’s portfolio? Even if you conducted a fair lending risk analysis a few months ago, the interest rate rise has rendered your analysis out-of-date. Your bank may be presiding over a host of unfair decisions that you have yet to discover.

3. Penalties for Violations are Growing More Severe.
If your institution commits a fair lending violation, the consequences could be more severe than ever. It could derail a merger or acquisition and cause a serious reputational issue for your organization. Regulators may even hold bank leaders personally liable.

In a recent lecture, CFPB Director Rohit Chopra noted that senior leaders at financial institutions — including directors — can now be held personally accountable for egregious violations:

“Where individuals play a role in repeat offenses and order violations, it may be appropriate for regulatory agencies and law enforcers to charge these individuals and disqualify them. Dismissal of senior management and board directors, and lifetime occupational bans should also be more frequently deployed in enforcement actions involving large firms.”

He’s wasting no time in keeping this promise: the CFPB has since filed a lawsuit against a senior executive at credit bureau TransUnion, cementing this new form of enforcement.

How can banks manage the current era of fair lending and minimize their institutional and personal exposure? Start by recognizing that the surface area of fair lending risks has expanded. Executives need to evaluate more decisions for fairness, including marketing, fraud and loss mitigation decisions. Staff conducting largely manual reviews of underwriting and pricing won’t give company leadership the visibility it needs into fair lending risks. Instead, lenders should explore adopting technologies that evaluate and imbed fairness considerations at key parts of the customer journey and generate reporting that boards, executive teams, and regulators can understand and rely on. Commitments to initiatives like special purpose credit programs can also effectively demonstrate that your institution is committed to responsibly extending credit in communities where it is dearly needed.

No matter what actions you take, a winning strategy will be proactive, not reactive. The time to modernize is now, before the old systems fail your institution.

Supreme Court Ruling Could Impact Your Bank

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disparate-impact-10-16-15.pngOn June 25, 2015, nearly four years after first agreeing to consider the question, the Supreme Court issued a decision in the case Texas Dept. of Housing and Community Affairs v. Inclusive Communities Project, Inc., holding that disparate impact claims may be brought under the Fair Housing Act (FHA). The Court’s decision confirms that, irrespective of intent, an institution engaged in residential real estate-related transactions such as mortgage lending may be held liable for a practice that has an adverse impact on members of a particular racial, religious, or other statutorily protected class.

However, the Court pointed out the following important limitations on the ability of plaintiffs to raise claims:

  • It is not sufficient to point out statistical disparities alone. Instead, plaintiffs must show that a defendant’s policy or policies caused that disparity.
  • Policies may only be challenged under disparate impact analysis if they are “artificial, arbitrary and unnecessary barriers.”
  • A defendant’s valid business justification may not be rejected unless a plaintiff identifies an alternative practice that has less disparate impact while still serving the entity’s legitimate needs.

To receive the benefit of any heightened standard resulting from the Court’s opinion, however, financial institutions must be willing to litigate. To avoid litigation in the first place, experience has shown that proactive steps taken by financial institutions can protect against possible disparate impact claims. Those steps include, for example:

Internal Audits and Fair Lending Risk Analysis
Financial institutions should be proactive in identifying and analyzing lending portfolios to identify areas susceptible to statistical challenge. One of the most reliable methods of doing so is to conduct routine statistical self-assessments on a portfolio-wide basis, appropriately structured to ensure attorney-client privilege will apply. Institutions should conduct periodic assessments, analyze the results (including file reviews of any outliers), and tailor policies and procedures to address the results, thus ensuring the institution is alert to potential disparities and can address any fair-lending related issues before they become supervisory concerns.

Policies and Procedures
Institutions should carefully review their policies and procedures to identify instances in which discretion is permitted in any aspect of underwriting or other credit processes, as discretion may give rise to discriminatory results. To the extent policies and procedures allow for discretion or exceptions, institutions should craft corporate governance mechanisms to approve such exceptions or departures from common practice as well as record keeping procedures to ensure proper documentation. In effect, the financial institution is creating a record of why it departed from its normal business practices. To the extent that the institution considers any changes to its policies and procedures as a result of its review, senior management should articulate the business- or risk-related reasons why such changes were or were not made.

Corporate Governance and Documentation
With increased scrutiny from regulators on fair lending issues, any business decisions that may involve practices that could have a disparate impact on a protected class, such as changing or discontinuing a particular product or service, should be carefully considered and the justifications for them should be clearly documented. Institutions should establish corporate governance procedures that provide for review of material changes to product and services offerings by senior management and fair lending/risk committees. The results of the review, including assessments of the reasons for the business decisions at issue, should be documented through meeting minutes and other records.

The Inclusive Communities decision almost certainly will embolden private plaintiffs and government agencies to assert claims of disparate impact discrimination. Proactive steps taken now can head off years of litigation and costly settlements by preventing statistical disparities from ripening into claims of discrimination. Financial institutions should aggressively review and enhance their compliance efforts to ensure the compliance of their business policies and practices.

Regulatory Punch List of Top Priorities for Bank Directors

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8-26-13-Wolters.pngIn today’s banking world, exams are tougher, the supervisory focus is on fairness to consumers, data is heavily scrutinized and consequences for failing to mitigate risks are more severe than ever. It is incumbent upon bank directors to stay in front of high risk areas and make sure their institutions can survive and thrive in this challenging environment. I put together my punch list of some of the top challenges I see facing the industry to provide guidance on where you will want to focus.

Get Serious about Complaint Management
The Consumer Financial Protection Bureau (CFPB) continues to amass an unprecedented public database of complaints against specific financial institutions. The CFPB’s complaint system is informing many of their decisions about whom to examine and how to regulate. In the face of this, banks should strive to improve their own internal complaint systems. You don’t want those complaints going to the bureau. You want them coming to the bank so you can solve them.

Be Extra Vigilant When Choosing and Managing Vendors
Regulators are looking more closely at the way banks choose and manage their vendors and are holding banks responsible for the faults of their vendors. In fact, recent enforcement actions from the CFPB resulted in a combined $101.5 million in fines plus $435 million in restitution for the financial firms based on flaws in the way the banks monitored their vendors. Additionally, the CFPB issued a bulletin in April 2012, with the message that banks are responsible for any faults of the vendors they work with.

Don’t Let the Ease of Social Media Make Things Difficult
In the social channel, which demands quick responses, an outsider may see what he perceives to be a run-of-the-mill consumer complaint and hastily respond in a way that causes more trouble. Be sure to monitor social media activity continually in real time.

Don’t Wait for Clarity from Regulators—Monitor, Test and Correct Fair Lending Issues Now
The recent OCC order that hit a bank for discriminating against white males may have taken some bankers off guard, and moved several to demand more clarity from regulators. But in this enforcement heavy environment, the best option is for banks to heavily monitor, test and correct, when necessary, all of their credit products now.

Solidify a Regulatory Reform Process
In our Regulatory & Risk Management Indicator survey in June, we asked bankers which regulatory concerns keep them up at night, and 46 percent said regulatory reform—referring to new rules stemming from the Dodd-Frank Act and the CFPB. Make sure your bank can address three primary questions relating to compliance programs:

  1. What are the laws and regulations you are subject to across all the jurisdictions in which you operate?
  2. Are you confident you are complying with all of these laws and regulations?
  3. Can you prove it to third parties (e.g., board members, investors, regulators and other stakeholders)?

Leverage Technology to Adjust to Onslaught of New Rules
Once upon a time, when a bank had an enforcement action of a significant deficiency, the first thing senior management used to say was: Where is our chief compliance officer? How did this happen? Now the question is going to be: Where is our chief technology officer? Why didn’t technology come up with the means to implement these changes in a more effective, efficient and compliant way? If technology and compliance aren’t talking to each other, they need to get together.

When it Comes to Auto Lending, Be in the Driver’s Seat
The CFPB is cracking down on interest rate markups that automobile dealers add to the cost of car loans. If they’re done in a discriminatory manner, then the bank is responsible. The CFPB recently released a bulletin that said lenders must enhance their oversight of auto dealers with which they do business after a recent investigation revealed disparities in interest rates charged to minority borrowers versus non-minorities. The bigger-picture problem for banks is that the regulatory scrutiny requires them to monitor the loans being made by all of the auto dealers they work with. That’s sometimes more than 1,000 dealers. The CFPB is hoping that lenders will voluntarily place compensation restrictions on dealers.

Watch out for UDAAP
The Dodd-Frank Act adds an “A” (which stands for abusive) to UDAP—turning the Federal Trade Commission’s provisions into “unfair, deceptive or abusive acts or practices.” A lot of it depends on the consumer’s ability to understand what is being presented to them. The gap between what is presented to customers and how they perceive what they get as well as its value is where the danger appears to lie. From the moment that a deposit or mortgage product or service is developed and the process begins, compliance folks have to have a seat at the table. I recommend that banks perform some testing to be sure the information being conveyed is perceived by the consumer the way it was meant to be. If there is a complaint, and that complaint goes to the bureau, the lender is going to have to be prepared to defend his ability to provide a product that was not unfair, that was not deceptive and certainly was not abusive.

Gear up for New Mortgage Rules
Several new mortgage rules are on their way from the CFPB. Among the new rules is the QM, or qualified mortgage (ability-to-pay) rule, a provision related to high-cost mortgages, a rule impacting loan officer compensation, new servicing standards, an escrow rule about impounding accounts and tax insurance, an appraisal disclosure rule and another appraisal guideline related to high-cost mortgage. Even now that the QM rule is final and going into effect in January, the industry still has to focus on the qualified residential mortgage (risk-retention rule) and its impact on mortgage lending and the secondary market. For much of the industry, setting up systems to comply with QM is a big concern. Also, we still must find out how all these different rules conflict with each other. It will certainly be a challenge.